Alternative Credit - increased opportunity from market disruption

Economic Outlook

Over the past 18 months, the market has experienced successive headwinds and volatility from geopolitical events including: the on-going Ukraine war and its consequences on the global economy; inflation shocks leading to aggressive central bank actions; liquidity shocks following the UK Gilts sell-off; and, more recently in March, the crisis of confidence in global banking.

Despite these ongoing headwinds, economic activity in Q1 has proved resilient and better than initially feared. However, concerns about global banking risk have caused tighter credit conditions and act as additional headwinds to economic activity. Global growth is expected to slow, with recession risks notably higher in the US. Headline inflation continues to fall but core inflation, which excludes food and energy, remains elevated and appears slower to retrace. That has required central banks to keep raising rates.

With liquidity reduction and banks’ lending conditions already tightened, the recent turmoil in the banking sector should further increase the role of alternative lenders. Long-term investors should remain opportunistic as the banks’ withdrawal gives them greater bargaining power and discretion when addressing this funding gap. As repricing has happened in both public and private markets, valuations are looking increasingly attractive. However, differentiation and credit selection are key in these market conditions, and we favour a defensive positioning.

Banking sector

With the lack of bank lending capacity, many corporate and commercial borrowers will not be able to refinance without large equity injections and/or at much higher interest rates. However, we expect the alternative credit market to bridge this gap. The transition to less abundant liquidity is continuing with the Fed’s balance sheet reduction, the ECB’s exit of purchase programs and the higher financing cost and tighter credit conditions from local banks in most countries. While increased rates tend to be positive for banks from a profit standpoint – since they can take advantage of the greater spread between the interest paid and received – the rapid increases over the past year have badly impacted their asset and liability matching. In the US, the banking model is currently challenged as deposits are being redirected into T-Bill or Money Market funds to capture yields. In Europe, one consequence of the recent crisis of confidence in the banking sector is that banks are now more conservative in the way they manage their balance sheets.

Market volatility & default outlook

Considering the numerous macro headwinds and ongoing geopolitical risks, market volatility should remain in 2023. Tighter lending standards and shallower debt markets will continue to create opportunities for direct lenders. The rapid increase in rates will also likely lead to fiscal sustainability issues, especially for countries with high debt levels and fragile public finances. Elevated currency volatility will remain in the near term as markets are still looking for signs of a ‘pivot’ by central banks.

Worsening macroeconomic conditions should lead to higher defaults rates, notably in sectors more impacted by recession risk. However, overall default levels should be manageable and we see default rates increasing to long-term averages of around 3% during 2023 and 2024. Fundamental credit selection and sector differentiation will be of heightened importance and we believe the focus should be on sectors and companies with pricing power and the ability to pass through inflation. Companies that benefit from high liquidity coverage through cash flow generation and interest rate hedging will also be attractive.

Asset classes in focus

Leveraged Loans

We believe there are currently attractive entry points in the asset class, provided tail risk is managed and minimized. Rising rates have benefitted Leveraged Loans investors since the loans pay a floating rate.

On the risk side, we don’t expect a significant increase in default rates. Rather, they should increase to long-term averages over 2023 and 2024, but this highlights the importance of fundamental credit selection and sector differentiation, notably:

· Focus on sectors/companies that have pricing power and ability to pass through inflation.

· Focus on companies that benefit from high liquidity coverage through cash flow generation and interest rate hedging.

SRT

SRT provide capital relief to banks. For the banks, this helps reduce their risk-weighted assets. For investors, it provides exposure to banks’ core and performing loans book, with various underlying assets (Large Cap, Mid Cap, SME, CRE, Infrastructure, etc). This frees banks to redeploy capital to improve returns and expand commercial development. In return, the SRT investor receives a premium from the bank for loss protection. The SRT market has been growing rapidly in recent years – having doubled in size since 2016 – and we are seeing new issuance in countries that previously hadn’t participated in the SRT market, such as Canada and Germany. With the quality and diversification of underlying loan portfolios and the recent widening of spreads for SRT transactions, we believe SRT are currently one of the more interesting areas of the alternative credit space.

As SRT are floating rate notes, their all-in spreads have widened considerably over the past year. At the same time, investors have been able to demand better terms on SRT transactions such as implementing more conservative structures and tightening the constraints on what is included in the underlying portfolios.

We believe banks may struggle to raise capital after the turmoil at the start of the year. In our view, banks will continue to use SRT as an efficient instrument to generate capital relief. This is also driven by the fact that it has become more expensive for banks to issue equity and other capital instruments.

Combined, we believe that the increased issuance of SRT, wider spreads due to higher rates for longer, more cautiously selected reference portfolios and better covenants for investors makes SRT an attractive investment opportunity in the current market environment.