Questions on Alternative Credit from investors

Nov 30, 2017 Blog  Alternative Credit

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Gabriella Kindert published a very interesting article on Alternative Credit this week.  Below follows a summary of that article:

Alternative Credit is an investment category that has been growing rapidly for a few years.  This asset class refers to loans facilitated on the private market and not publicly traded.  Institutional investors had a few questions regarding this asset class.

Is the risk of private loans considerably higher compared to public bonds?

Private loans are often secured by assets or shares and the documentation is negotiated for each transaction – it is examined per project and the ratios can be included to reduce downward risks, such as a minimum interest coverage ratio.  These are monitored and if there is any breach, negotiations take place to find another solution.  This usually leads to a low default risk and a high recovery if things do go wrong.  Furthermore, many of the sub-asset classes in alternative credit have a floating interest rate which provides protection against raising interest rates.

How does Alternative Credit relate to other asset classes?

Investors not only diversify more with Alternative Credit, they are increasing their allocations to Alternative Credit as well.  Equities have high-risk impact and goverment bonds are currently providing too little return, so investors are looking for alternatives.

Alternative Credit can have irregular, or even unexpected amortisations, which means that the interest rate sensitivity is different from that of bullet bonds for example.  By synchronising the Alternative Credit portfolio with a Liability-Driven Investing strategy, one can ensure that the investment portfolio as a whole has the desired hedging features.  Fixed-income Alternative Credit especially can provide good alternatives for investors who want to reduce their dependence on interest rate derivatives.

What is the added value of an Alternative Credit investment?

Prices in each investment category are determined by a variety of factors such as complexity, illiquidity, risk factors, and supply and demand.  For loans, the focus is strongly on downside risks.  These often have complex structures and that is reflected in a complexity premium – investors want compensation for the lack of liquidity as well.

Then there is the complexity of the market – how easy or difficult it is to bring buyers and sellers together, as well as the probability of default.  The liquidity of public bond market has also changed by regulation – banks are allowed to hold fewer bonds on their books due to changed regulations.  At the same time, there is a concentration of global holdings at buy-and-hold investors and central banks.  Recently, the tradability of government and corporate bonds turned out to be problematic due to liquidity so it is questionable whether they really take cost of liquidity into account.

Is an Alternative Credit investment extremely illiquidy?

There are differences in the degree of illiquidity – in normal functioning markets, there is a sound secondary market, but it can be a lot harder to find a buyer for other types of loans.  Liquidity can however dry out quickly as it the intention of buyers and sellers changes over time.  When investing in loans, it is important to take the lower liquidity into consideration, which means adopt a buy-and-hold mind-set – assume that the investment cannot be sold and carefully assess the potential consequences.

Liquidity risks can be mitigated by focussing on redeeming Alternative Credit sub-categories and there are ways to create liquidity, e.g. by investing in short-term self-liquidating assets.

Is this a good time to invest in Alternative Credit?

Yes, but be selective and take the risks into account.  Today’s market is different to what it what is 2008-2009 when there were severe discounts on asset values and an overall lending gap – investors need to run the extra mile to assess transparency.  Overall though, private markets offer a premium versus the public market which will not disappear shortly as the credit shortage for banks has not yet been resolved in many asset classes and the compensation for higher complexity and lower liquidity will remain.

It does however take a relatively long time to build up a loan portfolio as closing loans may take weeks to months and the asset manager’s network has to be leveraged for investment opportunities.  This takes more time than building up a bond portfolio for example.

To read the full article, click here.

Image: Alan Naul via Flickr (CC 2.0, resized)

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