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Debt in demand
Debt in demand
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Debt in demand

29/05/2017

Andrew Dougherty

Andrew Dougherty

North American Head of Alternative & Institutional Solutions

BNP Paribas Securities Services

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Demand for non-correlative investment opportunities is increasing at the institutional level

With interest rates remaining historically low, despite increased Federal Reserve intervention, demand for noncorrelative investment opportunities continues unabated at the institutional level. Recent data shows investors who are seeking alternatives to equities or other go-to asset classes are increasingly considering private debt-oriented strategies. And with good reason: unlike standard bond investment portfolios, which remain relatively static, debt-fund loan rates are in a constant state of flux, which can benefit investors, particularly during periods of tightened monetary policy.

With capital inflows on the rise and competition for institutional allocations growing simultaneously, many managers have expanded their menu to include more sophisticated debt structures covering a wider range of strategies/maturities. While the US has long been dominant in the debt field, Europe has recently shown its own strength, particularly as new regulatory proposals clear the way for non-banking capital providers to emerge.

Alternative Lenders

Changes to institutional capital requirements post-crisis have increasingly reduced banks’ lending capacity, impacting market liquidity, while also depriving small-to-medium sized companies of crucial operating capital. Opportunistic hedge funds, however, have sought to fill this funding gap by acting as alternative liquidity providers to a number of segments, with borrowers ranging from sub-investment grade mid-tier corporates, to real estate and infrastructure projects, as well as healthcare and consumer-goods and services firms.

Unlike higher liquidity based hedge fund strategies that offer investors redemption opportunities following a brief lock-up period (usually one year, on average), debt funds, which are typically non-exchange traded, bilateral agreements, can be far more restrictive (the exception being open-ended loan funds, which have limited or zero lock-up provisions and also typically avoid illiquid or sub-investment grade holdings). Even so, demand has been such that, in many instances, investors have been willing to forego redemption privileges in order to gain exposure to the emerging asset class.

This, of course, is in sharp contrast to the more risk-averse, post-crisis period in which investors required continual and unabated access to their capital. Nevertheless, with rates barely budging and equities currently hitting record highs, the desire to secure non-correlated absolute returns has, at least for the time being, trumped such concerns. However, as the pool of institutional investors grows deeper and supply increases, the asset class has in turn become more orderly and efficient.

Rising Rates, Higher Returns

Because their rates are continually re-adjusted to reflect current market metrics, debt funds are generally less sensitive to interest rate moves than standard fixed-income vehicles. Thus, while stronger economic activity can often weigh on longer-duration bonds as rates move up and coupon prices fall, such conditions bode well for debt fund investors, whose income payments rise due to the funds’ floating-rate structure. Recent figures underscore the value of debt funds relative to standard fixed-income investments: during the second half of 2016, US loan yields easily outperformed the market for investment-grade fixed-income securities, returning 5.5% through the period according to Bloomberg (compared to -1.5% for bonds).

With expectations for a sustained round of Fed tightening all but baked in (including an additional five rate hikes through the end of 2018), market participants have joined the debt queue en masse.

According to Preqin, as of early 2017, private debt AuM stood just shy of $600bn, a four-fold increase over the past decade, with public and private pension funds accounting for more than half (56%) of debt-fund allocations. With recent debt-fund performance comparable to historical equity returns, not surprisingly two-thirds of investors polled by Preqin indicated a willingness to boost allocations going forward.

Perhaps the most positive development of late has been the upward momentum of LIBOR, which has nearly quadrupled over the last two years (as of this writing the 3-month LIBOR stands at 1.16, the first time the rate has eclipsed 1% since the start of the credit crisis). Because LIBOR is used by lenders as the base benchmark when re-pricing variable short-term loans (to which a fixed margin or “spread” is also added, ranging anywhere from 125-400bps or more), the current trend is viewed positively by debt investors, who have seen quarterly income steadily rise with the LIBOR uptick.

A better bet than bonds?

Like any off-market investment strategy, debt funds are not nearly as liquid as those traded on-exchange, and accordingly may not be appropriate for the risk-averse. As investors grow more comfortable with higher-yielding, sub-investment grade debt securities, however, debt fund AuM is expected to maintain its upward trajectory, particularly as banks continue to steer clear of the non-investment grade lending space.

As private debt instruments do not trade on exchange, nor have a central-clearing agent, the operational complexities are such that tracking income, rate-resets, reconciliation and other data can easily overwhelm a fund’s human resources. Additionally, with the market heating up, many managers are offering investors greater diversity, including access to distressed issues, mezzanine debt, mortgage loans and other opportunities in an effort to gain a competitive advantage. Such strategies will only add to a firm’s operational complexity, however, and could prove particularly challenging for hedge funds that need to stay lean in order to succeed.

Accordingly, fund managers can benefit from a provider with the ability to offer transparent, cost-effective fund and loan administration across numerous debt classes, including tailored risk management particularly for those seeking higher-yielding/distressed opportunities. By eliminating the complexity and manual processes, service providers can play a crucial role from an operational efficiency standpoint, allowing fund managers to focus solely on identifying investible opportunities within this growing and attractive asset class.

Factors Supporting Debt Fund Growth

  • Alternative debt is increasingly viewed as an effective hedge against further interest rate hikes, as well as a possible equities correction
  • As their lending rates are continually re-set, debt funds often fare better in a rising rate environment
  • The potential for increased US infrastructure spending/corporate investing could create attractive new lending opportunities
  • As banks now face tougher capital/leverage requirements, hedge funds, along with private equity and other asset holders, have increasingly taken up the role of liquidity provider on behalf of small-cap corporates
  • Efforts to revise portions of Dodd Frank and other financial-industry legislation could be a positive for the segment going forward.

 

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