Are the warning signs already here?
Mark Landis & Timothy Yan
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KEY TAKEAWAYS
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Going back to Macroeconomics 101, the fundamental drivers behind market pricing remain growth and inflation expectations. Today’s market environment is a byproduct of different market influences including high inflation, tightening monetary policies, rapidly shifting geopolitical conditions, and a long-aged credit cycle all coming together at once, increasing risks to economic growth. The resulting volatility has helped fuel the dramatic declines that have taken place this year in public markets.
Figure 1: High Yield & Investment Grade Index Results (12/31/21 - 6/30/22),
For Illustrative Purposes Only
Source: Bloomberg, see appendix for index definition and disclaimers,
Past performance is no guarantee of future results
The speed and depth of these declines have caused many investors to look for potentially safer areas to invest but may have also given rise to harmful misconceptions about risk and reward in private markets.
The Rise of Private Credit
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With interest rates at historic lows for over a decade, many investors have flocked to private credit in an attempt to increase their yield and return over corporate bonds by taking on liquidity and non-rated credit risk. Assets in private credit funds reached a record $1.6 trillion as of March 2022 according to a report by Intertrust Group, a management company based in the Netherlands. That’s an increase of 53% in assets over the last five years. The rapid growth isn’t just a rise in AUM, there has been a 56% increase in the number of private credit funds over that same stretch (Figure 2).
Figure 2: Growth of # of funds by strategy over 5 years
Source: The Accelerated Growth of Private Credit, Intertrust Group
There is no guarantee that investment in any program or strategy discussed herein will be profitable or will not incur loss.
As the space has grown, so have the variety of offerings. Many investors are unaware of the different debt instruments that private credit is comprised of – each with its own idiosyncratic risk and return profiles. Private credit assets, when compared with their public counterparts, generally have an increased risk of default due to their opportunistic focus on companies with limited funding options. The less frequent pricing of private credit compared to the daily pricing of public debt can make it appear less volatile which can in turn give the perception of lowering volatility in investors’ portfolios. While this does help take some of the guesswork out of timing markets, being illiquid without a readily available price is not necessarily a great reason to invest.
Now facing rapidly rising inflation, a different feature is luring investors: floating rates, which in theory, should rise in line with interest rates. With few fixed income investments that could naturally benefit from rising rates, it’s not surprising that this category has grown at a feverish pace. Under the surface, however, things may not be as they seem.
One of the core fundamentals in asset and liability management is that one must have some floating rate liabilities against assets that are explicitly floating rate, or indirectly supported by higher inflation and interest rates. Precisely for this reason, most investment grade companies swap portions of their fixed rate liabilities into floating. Lower-rated companies generally have less cash than investment grade companies, but the basic rule still applies. Most companies look at the expected life of the liability, which in practice is generally closer to the first call date than to the final maturity of the loan. This usually means that the interest rate hedges they are using are put on for less time than the final maturity, so at some point, these companies revert to paying a floating rate from a fixed rate. Despite this mismatch, companies rarely disclose all of the details surrounding these hedges. As a result, while the floating rate nature of this sector of private credit may have less mark-to-market price sensitivity to interest rate moves, they still carry significant fundamental exposure to higher interest rates.
If the market expectations around the Fed’s path of interest rate hikes are realized, then it would be reasonable to expect a downgrade cycle on the companies issuing private credit, which are lower-rated than many of those in the high yield space, resulting in a repricing of their securities.
Conclusion
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As with any asset class, private credit strategies carry their own sets of risks. That doesn’t mean that they are not susceptible to higher interest rates, rising inflation, and slowing economic growth. Since the size of the private credit market has grown so rapidly, it is hard to draw a true apples-to-apples comparison when looking at past periods of market stress. However, we can examine how the publicly-traded high yield markets performed in previous recessionary periods.
So far this year, in an already stressed environment, we have seen high yield spreads go from 310 bps to almost 600bps (Figure 3), resulting in the index falling by over 13% from 12/31/21 to 6/30/22 (Figure 4). When looking through the lens of private credit, one would think that performance could be even more challenged since the default risk of the underlying companies may be higher.
Figure 3: ICE BofA US High Yield Index Option-Adjusted Spread *shaded areas represent U.S. Recessions
Source: Federal Reserve Bank of St. Louis
Past performance does not guarantee future results
Figure 4: High Yield Drawdowns During Prior Recessionary Periods vs. Present Conditions
For Illustrative Purposes Only
iBoxx USD High Yield Index, see appendix for index definition and disclaimers
Past performance does not guarantee future results
Source: Bloomberg, Federal Reserve Bank of St. Louis
One of the biggest challenges for investors when examining the private credit space is the lack of
data available – both current and historical. Business development corporations (BDCs) and closed-end funds, which are on the more liquid end of the private credit spectrum, offer us a glimpse into the space. While we have seen some drawdowns in recent months (Figure 5), there may be further repricings to come and we believe that investors should exercise caution when reviewing their risk profiles – especially when looking at the less liquid areas of the market. The perceived low volatility of these instruments as a result of less frequent repricing should not be confused with their actual volatility and liquidity characteristics.
Figure 5: INDXX Private Credit Index Results YTD – For Illustrative Purposes Only
Source: INDXX, see appendix for index definition and disclaimers
Past performance does not guarantee future results
Trying to time markets is never easy, but doing this in an illiquid vehicle without price transparency increases the challenge. As we’ve seen during past recessionary periods, market timing can have a huge impact on potential returns. We contend that the prospect of illiquidity (something that we’ll detail in a future research note) combined with heightened default risk puts even higher pressure on the private credit space and could result in losses greater than what we’ve seen so far and in the public markets, exacerbating the risk profile of investor portfolios.
While private credit has attracted many new investors over the recent cycle, it may also carry critical risks as we enter a new economic environment. In this context, we believe investors can benefit from a liquid approach that seeks to balance risk across the long-term drivers of asset prices we identified at the start of this piece: growth and inflation. We don’t have a crystal ball and with so much uncertainty on the horizon, we think it is prudent for investors to avoid making less liquid directional bets and instead seek to prepare their portfolios for a notably wide range of potential outcomes for the economy.
Appendix
The indices shown are for informational purposes only and are not reflective of any investment. As it is not possible to invest in the indices, the data shown does not reflect or compare features of an actual investment, such as its objectives, cost and expenses, liquidity, safety, guarantees or insurance, fluctuation of principal or return, or tax features.
Definitions:
iBoxx USD High Yield Index: The Markit iBoxx USD Liquid High Yield Index consists of liquid USD high yield bonds, selected to provide a balanced representation of the USD high yield corporate bond universe.
iBoxx USD Liquid Investment Grade Index: The Markit iBoxx USD Liquid Investment Grade Index is designed to reflect the performance of US Dollar (USD) denominated investment grade corporate debt. The index rules aim to offer a broad coverage of the USD investment grade liquid bond universe.
INDXX Private Credit Index: The Indxx Private Credit Index tracks the performance of the Business Development Corporations (BDCs) and Closed-End Funds (CEFs), trading in the US, with significant exposure to private credit, as defined by Indxx. The index has been backtested to August 31, 2013 and has a live calculation date of January 31, 2019.
Disclaimer:
Wavelength Capital Management, LLC (“Wavelength”) is an SEC-registered¹ investment adviser located in Connecticut. Wavelength may only transact business in those states in which it is notice filed or qualifies for a corresponding exemption from such requirements. Wavelength's website is limited to the dissemination of general information regarding its investment advisory services to United States residents residing in states where providing such information is not prohibited by applicable law. Accordingly, the publication of Wavelength's website on the Internet should not be construed as Wavelength's solicitation to effect, or attempt to effect, transactions in securities or the rendering of personalized investment advice for compensation over the Internet. Investing involves the risk of loss and investors should be prepared to bear potential losses. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. No portion of this commentary is to be construed as a solicitation to buy or sell a security or the provision of personalized investment, tax or legal advice. Certain information contained in this report is derived from sources that Wavelength believes to be reliable; however, the Firm does not guarantee the accuracy or timeliness of such information and assumes no liability for any resulting damages. For information pertaining to the registration status of Wavelength, please view the United States Securities and Exchange Commission’s website at www.adviserinfo.sec.gov. A copy of Wavelength's current written disclosure statement discussing Wavelength's business operations, services and fees is available from Wavelength upon written request. Wavelength does not make any representations as to the accuracy, timeliness, suitability, completeness or relevance of any information prepared by any unaffiliated third party, whether linked to Wavelength's website or incorporated herein, and takes no responsibility therefore. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.
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