INCREASED LEVERAGE
These warnings chime with other parts of the industry. According to Cambridge Associates managing director Himanshu Chaturvedi, leverage has crept up in parts of the market, particularly in corporate balance sheets, as a consequence of investors reaching for yield attracted by the floating rate nature of these loans. “There are investment products out there that have more leverage than we think,” he adds. “In the fixed income space we are seeing loans on loans; strategies that lend money and are then being levered up.
“The fact that these are in the market can be a warning sign, especially when you start to see these systematically popping up.” Chaturvedi is not alone in this observation.
Research by consultancy bfinance has noted leverage, and therefore risk, increasing in senior direct lending funds. It also found unitranche loans – those that combine senior and subordinated debt into one debt instrument – have gradually become more dominant in the senior portion as managers try to keep internal rate of return expectations on track despite spread compression.
Niels Bodenheim, director in private markets at bfinance, says investors should be careful of the structures and terms underpinning these loans.
“Increasingly complex models have emerged,” he adds. “We’re seeing lenders introducing a component of PIK [payment in kind] relative to cashpay in unitranche, enhancing returns but creating a more back-ended structure – deeper J-curve.
“We’re also seeing more cases where the unitranche is going deeper into the capital stack, which can be a source of concern for a loan classified as senior debt.” Bluebay head of credit strategy David Riley perceives the high yield bond market to have been tougher in terms of credit standards than areas of the leveraged loan market.
In the latter, there has been an increase in leverage and deterioration in covenant quality as investors have piled in to reduce the amount of interest rate risk because it is floating rate.
But some investors have become savvier when it comes to the amount of risk in their portfolios.
“Some investors are explicitly specifying that they do not want certain credits in the portfolio such as triple-C,” says Riley. “Or when moving into emerging markets they want dollar debt rather than high yield corporate or local currency debt.”
DIRECT LENDING
Elsewhere, like leveraged loans direct lending is becoming a popular source of yield in an environment where banks have retrenched from lending. A survey by Natixis found 74% of UK institutional investors think private debt provides higher risk adjusted returns than traditional bond investments. Drilling down, 46% of respondents said they are likely to increase use of direct lending and 41% expect to invest in collateralised debt.
The Nationwide Pension Fund, spearheaded by chief investment officer Mark Hedges, counts private debt among its 20% allocation to illiquid assets, while the Church of England Pensions Board recently allocated £80m to US private debt to capitalise on the illiquidity premium.
A report by direct lending service Bond Mason has found peer-to-peer (P2P), a less well trodden path for institutional investors, accounted for £3.2bn of lending in 2016, up 39% on 2015. The firm claims institutional investors now account for more than half of the capital flowing into direct lending.
But Stephen Findlay, chief executive at Bond Mason, believes direct lending is blighted by a significant governance problem.
This is something the Financial Conduct Authority (FCA) is currently probing, but Findlay believes this might not necessarily solve the issue. “Regulation doesn’t guarantee the quality of a platform,” he explains. “When investors are looking to deploy capital across P2P platforms, FCA authorisation will serve as a ‘badge of trust’, but just because a platform is FCA regulated that doesn’t guarantee good loans or good returns to lenders.”
