Despite the pandemic, distressed debt is not the main opportunity in the alternative credit sector, Willis Towers Watson argues.
Interest from institutional investors in alternative credit assets has increased as investors continue to search for yield and diversification of their credit portfolios.
But despite the turmoil caused by the coronavirus pandemic, distressed debt is not the most interesting area among alternative credit investments, according to Nick Kelly, Senior Investment Consultant with Willis Towers Watson.
“There are definitely opportunities [in distressed debt], but the challenge, of course, is that we saw a very quick rebound in both credit and equity markets [last year] and that becomes somewhat of a headwind for distressed [debt],” Kelly says in an interview with [i3] Insights.
There are definitely opportunities [in distressed debt], but the challenge, of course, is that we saw a very quick rebound in both credit and equity markets [last year] and that becomes somewhat of a headwind for distressed [debt]
“If you think about the global financial crisis, then that was a very ripe time for distressed credit, because that was a credit crisis. There was overleverage in most markets around the world, particularly in real estate, and so a lot of people made a lot of money playing in distressed real estate credit.
“You wind the clock forward and the last 10 years has been largely an equity bubble. So you look at valuations in real assets, it is not so much debt driven.
“When you get opportunities in distressed credit is when a bank has taken ownership of an asset and they have to flog off non-performing loan portfolios. And because this cycle is probably more equity driven, there is probably less leverage across the board than in ‘06, ‘07 or ‘08, where everyone was borrowing to the hills and then the bank came in to enforce.
“You don’t have that now.
“So I think there will be opportunities, but I think it is going to be more isolated.”
More interesting areas are those parts of the alternative credit universe that are more niche and where more specialised skill is required, Kelly says.
One particularly interesting area is bank replacement strategies, where asset managers have stepped in to provide insurance-like contracts against the default of parts of a bank’s loan book.
“It is a form of regulatory capital arbitrage. Banks are all facing a raft of regulations in the form of Basel III and Basel IV regulations and so like insurers they need to hold capital against [their loans],” Kelly says.
“They can go and raise more equity capital or they can work with an asset manager and the manager gives them in effect an insurance contract over the first loss of a series of those loans.
“If you imagine that the bank lent someone 60 per cent of the value of their house and there is 40 per cent in equity, right? What the asset manager would do is say ‘look, I’ll take the first loss piece’, which might be an 8 per cent tranche, the first 8 per cent. So the bank then holds only 52 per cent.
the cost of equity for the average bank is about 12 per cent. So you are getting paid somewhere between 10 and 12 per cent to go and provide an insurance line on a well-diversified pool of assets
“It is effectively an insurance contract. The bank still services those loans, so the underlying borrowers don’t see any difference. And you get regulatory approval to do these deals.
“The bank is willing to pay up to the cost of equity to do this because their only alternative is to go and raise equity capital in order to comply with the regulations.
“Now, the cost of equity for the average bank is about 12 per cent. So you are getting paid somewhere between 10 and 12 per cent to go and provide an insurance line on a well-diversified pool of assets.
“They are typically mature assets, they might be on a suite of infrastructure deals that were underwritten 5 to 10 years ago with very little construction risk and you are sitting there earning cash plus 10 per cent. That seems to be a good space to be in.”
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.