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Plain sailing - how credit beat the crisis and can beat inflation too
CVC Portfolio Manager Pieter Staelens has been featured in LPeC's 2021 Annual Market Review discussing the role of credit in private finance. The full report is available on the LPeC website.
Despite the severe curtailment of economies around the world in 2020, asset markets performed very strongly. The willingness of developed-market central banks to underwrite equity risk as a by-product of doing "whatever it takes" to protect economies from COVID-19 has played a crucial role, freeing investors from the shackles of "risk vs return" and allowing them to focus purely on relative expected returns. In leveraged finance, which is where our fund focuses, this has meant that riskier credits have performed much better than expected, pushing down yields on leveraged loans to levels similar to those that existed at the beginning of 2020.
Private credit certainly proved its mettle in this crisis. Default rates on leveraged loans peaked at around 2.5% last year, far below the 10% level they reached in the global financial crisis. Even this peak was short lived and defaults quickly returned to the 5-year 1.3% average. Not only that, but loans typically have security over good collateral so recovery rates on loans in default were very high – around 75% across the market.
The impact of loan losses on returns, despite the worst recession in two centuries, was therefore only around 0.3% against a typical yield (or interest rate) of around 4%. Very few companies now see their loans trading at distressed valuations (fewer than 1 in 100). Therefore, even as government support is removed we do not expect default rates to rise significantly because economic growth looks encouraging.
Perhaps counter-intuitively, we also see the leveraged loan market as a hedge against inflation. Inflation has risen everywhere, partly as a transitory rebound related to shorter-term supply constraints and the unleashing of pent-up demand, but higher inflation may persist longer than some think. Policymakers clearly intend to run their economies hot for a time – there is little sign of significant fiscal tightening and central banks remain committed to providing support. But central banks will not tolerate an inflation overshoot indefinitely and will raise rates to meet the challenge.
On the other hand, a lot of investors have become used to ignoring interest-rate risk in their portfolio. For those who still want to generate a secure, reliable income from their credit allocations, leveraged loans provide an often-overlooked alternative. As base rates rise, so the interest rates on leveraged loans will rise too and, unlike in the bond markets, capital values should not be affected by this sea-change.
The market for leveraged loans is growing strongly this year, driven by the record boom in mergers and acquisitions (M&A) and from the dramatic uptick in private equity deal flow, especially in markets like the UK where company valuations are still low compared to the US, for example.
From a sector perspective, we are relatively defensively positioned now, with loans to healthcare companies, for example, offering good downside protection. Last year we made the most of opportunities to buy loans to selected hospitality and travel businesses at distressed prices, but if anything, the market is now unrealistically expecting a quick return to normality for these sectors, so opportunities are thin on the ground and we are a lot more selective here.
About CVC Partners Credit Opportunities Ltd
There are two main markets for corporate borrowing, beyond traditional bank lending. There are the bond markets, where companies issue a bond at a fixed interest rate and pay back their loan in full at the end of its term. And there is the leveraged loan market, where an investment bank arranges a loan for a borrower and funds like CVC Credit Opportunities provide the capital.
For the most part, listed companies use the bond markets while privately owned companies tend to rely on leveraged loans. Bonds and leveraged loans are bought and sold regularly on the secondary market – the former via exchanges and the latter in so-called over-the-counter (OTC) deals.
The most important difference is that leveraged loans have a floating rate of interest which rises and falls as market rates move. The price of a leveraged loan therefore tends to remain close to the initial issue value, except when a company is thought to be in trouble. If investors fear for a company’s future, they will demand a discount and the loan will change hands below par, sometimes substantially so.
This is where the real opportunities lie. Our flexible investment strategy also allows us look for companies whose loans are trading at a discount and consider whether that company can work through its problems before the loan is due for repayment. If it can, there is a capital gain to be made as well as an income that comes from the interest payments. For this reason, we spend a lot of time carefully getting to know and understand the companies whose loans we buy. Most of the time, these companies are owned by private equity funds – they provide equity finance and we provide private credit funding.
Our fund manages €700m of such assets, mainly in Europe and the UK with a small portion in the US, but the leveraged loan markets are much bigger than this, with the loan market having more than doubled in value to €360bn in the last five years. This is a large, liquid and growing market that continues to provide opportunities for investors who want a reliable income with a hedge against inflation.