After a slowdown in issuance that mirrored public markets during the first month of the global pandemic, investment grade private credit markets sprang back to life in late April and May. Investors were able to source attractive deals at significant yield premiums to similarly rated public bonds. Additionally, active managers continue to exploit market dislocations and generate strong risk-adjusted returns for clients by adding high-quality assets at historically compelling spread levels.
We believe there is a long-term role for both public and private fixed income in investors’ portfolios. Investment grade private credit complements public credit by adding additional spread premium and diversification while retaining a high correlation to long-term financial liabilities.
What is investment grade private credit?
Investment grade private credit¹ refers to loans and debt securities issued by companies or entities outside of the public capital markets. Investors are primarily institutions such as insurance companies and pension funds.
- Investment grade private credit instruments are similar to public debt. They typically have durations that range from five to 30 years, often include collateral and financial covenants and are available across the rating spectrum.
- Investors are paid a spread premium over comparable public bonds because these transactions are more customized and less liquid.
- The private placement issuer base includes public and private corporate issuers and spans major sectors (industrials, utilities, financials).
- Annual issuance in the investment grade private credit market is $70 to $100 billion per year and growing, with the U.S. representing about 60% of annual volume.
Investment grade private credit vs. public bonds and below investment grade private credit
|Investment grade public corporate credit||Investment grade private credit||Below investment grade
|Issuers/obligors||Large corporations||Companies, governments, non-profits||Mid-market companies|
|Use of proceeds||General corporate purposes||Project and asset specific||Leveraged buyouts|
|Rating||AAA-BBB||Typically A-BB, some AA||BB+ and below|
|Security||Unsecured||Secured and unsecured||Secured and unsecured|
|Ranking||Can be subordinated||Senior||Senior and subordinate|
|Covenants||Limited||Maintenance / comprehensive||Pressure due to increased competition among lenders|
|Tenor||5, 7, 10, 30 years||Flexible 2-30 years||Typically 5 years|
|Historic spread to comparable public credit||N/A||10 - 100+ basis points||50 - 400+ basis points|
|Annual issuance||$1.2 - $1.3T||$70 - $100B||$200B+|
Why investment grade private credit?
The strength, durability and growth of the investment grade private credit market reflects the wide range of benefits afforded to both issuers and investors.
Benefits to borrowers of investment grade private credit issuance:
Features and deal terms of investment grade private credit can be highly customized to meet the needs of the issuer and include non-standard maturities, delayed or multiple draw periods and custom amortization.
Issuers of investment grade private credit can bypass the time and expense associated with public disclosure and registration requirements, allowing private issuers to maintain confidentiality.
Knowledgeable investor base
Most investment grade private credit investors are affiliated with larger investment management organizations with dedicated analysts capable of underwriting unique or complex transactions that would be difficult to execute in the public market. Issuers also value the ongoing relationship with private investors as a source both of capital for growth and structuring expertise.
Benefits to investors of investment grade private credit markets:
The investment grade private credit market offers investors the opportunity to invest in unique transactions and issuers not available to public bond investors.
A combination of the illiquidity premium and bespoke nature of investment grade private credit placements relative to public bonds allow investors to capture a spread premium over comparable public issuers, as well as the potential for additional income associated with consents, amendments and, in some cases, coupon increases.
Better lender protections
Investment grade private credit investors benefit from deal structures that are typically more robust than public market transactions, including collateral and financial covenants that allow investors to get back to the negotiating table in the event of credit deterioration. Investors also benefit from direct access to management along with access to information not available to public investors.
Applications for Insurance Companies
The attractive capital efficient yields have made investment grade private credit an integral component of life insurer’s portfolios, and in recent years, there has been significant adoption within the Property and Casualty (P&C) segment as well. P&C insurers look for ways to add yield without taking on additional credit risk or exposing themselves to regulatory charges, and investment grade private credit can effectively deliver these characteristics to the portfolio.
Capital framework treatment
Investment grade private credit is typically treated like any other fixed rate corporate debt security from an accounting and capital perspective. On a capital-adjusted basis, investment grade private credit presents insurers the opportunity to add attractive yield to their portfolios at a similar capital charge to traditional public debt.
Statutory and Regulatory Treatment
From a statutory filing perspective, investment grade private credit is disclosed on Schedule D Part 1 (Bonds) as an Amortized instrument, in line with traditional public debt. Similarly, the Risk Based Capital charges for investment grade private credit correspond to a NAIC 1 – 2 bond, depending on the rating.
Regulatory Modeling (AM Best BCAR, Moody’s, S&P)
About 80% of investment grade private credit deals have nationally recognized statistical rating organization (NRSRO) ratings, and the remaining balance is filed directly with the securities valuation office (SVO). In most cases, ratings agencies do not penalize investment grade private credit relative to traditional public fixed income. BCAR, Moody’s and S&P all treat investment grade private credit similarly to other fixed income securities that have a corresponding rating. However, Moody’s and S&P may apply a minor liquidity premium if they feel investment grade private credit allocations are excessive.
Historical allocation of private fixed income
Source: S&P Global Intelligence as of 12/31/2019. NAIC Industry Data as of 12/31/2019.
Investment track record
Investment grade private credit has historically provided higher yields than public bonds with comparable duration and ratings. In addition to higher yields, investment grade private credit has performed better than public bonds with respect to defaults and losses3. Restrictive terms and financial covenants allow investment grade private credit investors to identify and resolve credit issues before an actual default occurs.
SLC Management’s private credit team has generated an average annual spread premium, or relative value, of 87 basis points over the past six years. Our focus on niche sectors and transactions with structural complexity allow us to deliver attractive risk-adjusted returns for investors.
SLC Management’s average annual default rate has been 23bps since 2008 compared to 34bps for Moody’s equivalent benchmark. Additionally, our average annual loss rate was 6bps compared to Moody’s at 20bps.
Notes: (1) U.S. currency and fixed rate transactions. (2) Represent weighted average of the U.S. Private Fixed Income portfolio. See footnote 2 or disclosures at the end of the piece for a summary of the methodology used to estimate relative value to appropriate public benchmarks.
3 Source: NAIC (National Association of Insurance Commissioners), The Centre for Insurance Policy and Research, January 9, 2019.
Investment grade private credit is a capital efficient asset class that can offer investors the potential for excess returns, lower downgrades and defaults and provide a natural hedge for long-term liabilities. SLC Management has a long history of active management in both public and private fixed income markets and is focused on adding consistent value for our clients.
1 Investment grade credit ratings of our private placements portfolio are based on a proprietary, internal credit rating methodology that was developed using both externally-purchased and internally developed models. This methodology is reviewed regularly. More details can be shared upon request. Although most U.S. dollar private placement investments have an external rating, for unrated deals, there is no guarantee that the same rating(s) would be assigned to portfolio asset(s) if they were independently rated by a major credit ratings organization.
2 87 basis points over relative value is the 6 year average for private fixed income USD fixed rate deals. The relative value over public benchmarks estimate is derived by comparing each loan’s spread at funding with a corresponding public corporate bond benchmark based on credit rating. Loans that are internally rated as “AA” are compared to the Bloomberg Barclays U.S. Corporate Aa Index, loans rated “A” are compared to the Bloomberg Barclays U.S. Corporate A Index, while loans rated “BBB” are compared to the Bloomberg Barclays U.S. Corporate Baa Index. For certain power and utility project loans, a best fit approach of a variety of Bloomberg Barclays’ indices was employed prior to September 30, 2016. After this date, these types of loans were compared to Bloomberg Barclays Utilities A Index and Bloomberg Barclays Utilities Baa Index, for “A” and “BBB” internally rated loans, respectively. Relative spread values obtained through the above methodologies were then aggregated and asset-weighted (by year) to obtain the overall spread value indicated in the piece.
This paper is intended for institutional investors only. The information in this paper is not intended to provide specific financial, tax, investment, insurance, legal or accounting advice and should not be relied upon and does not constitute a specific offer to buy and/or sell securities, insurance or investment services. Investors should consult with their professional advisors before acting upon any information contained in this paper.
SLC Management is the brand name for the institutional asset management business of Sun Life Financial Inc. (“Sun Life”) under which Sun Life Capital Management (U.S.) LLC in the United States, and Sun Life Capital Management (Canada) Inc. in Canada operate. Sun Life Capital Management (Canada) Inc. is a Canadian registered portfolio manager, investment fund manager, exempt market dealer and in Ontario, a commodity trading manager. Sun Life Capital Management (U.S.) LLC is registered with the U.S. Securities and Exchange Commission as an investment adviser and is also a Commodity Trading Advisor and Commodity Pool Operator registered with the Commodity Futures Trading Commission under the Commodity Exchange Act and Members of the National Futures Association. Registration as an investment adviser does not imply any level of skill or training.
There is no assurance that the objective of any private placement strategy can be achieved. The principal risks associated with the Advisor’s private placement strategies are described as follows. As with any strategy, the Advisor’s judgments about the relative value of securities selected for the portfolio can prove to be wrong.
(1) Interest rate risk involves the risk that interest rates will go up, or the expected spread to the benchmark will widen, causing the value of the portfolio’s fixed income securities to go down. This risk can be greater for securities with longer maturities and the widening of spreads can continue for an extended period of time. (2) Credit risk is the risk that the issuer of fixed income securities will fail to meet its payment obligations or become insolvent causing the market value of the securities to decrease. Private placements are not rated by the credit rating agencies. Any ratings assigned to this debt is the product of analysis performed by the Advisor and or Advisor’s affiliates. (3) Liquidity risk is the risk that Advisor may be unable to sell a given security at an advantageous time or price or to purchase the desired level of exposure for the portfolio. At times this market has experienced severe illiquidity and/or significant price impacts. (4) Counterparty risk involves the risk that the opposing party in a transaction does not fulfill its commitments.
Investment grade credit ratings of our private placements portfolio are based on a proprietary, internal credit rating methodology that was developed using both externally-purchased and internally developed models. This methodology is reviewed regularly. More details can be shared upon request. Although most U.S. dollar private placement investments have an external rating, for unrated deals, there is no guarantee that the same rating(s) would be assigned to portfolio asset(s) if they were independently rated by a major credit ratings organization.
The relative value over public benchmarks estimate is derived by comparing each loan’s spread at funding with a corresponding public corporate bond benchmark based on credit rating. Loans that are internally rated as “AA” are compared to the Bloomberg Barclays U.S. Corporate Aa Index, loans rated “A” are compared to the Bloomberg Barclays U.S. Corporate A Index, while loans rated “BBB” are compared to the Bloomberg Barclays U.S. Corporate Baa Index. For certain power and utility project loans, a best fit approach of a variety of Bloomberg Barclays’ indices was employed prior to September 30, 2016. After this date, these types of loans were compared to Bloomberg Barclays Utilities A Index and Bloomberg Barclays Utilities Baa Index, for “A” and “BBB” internally rated loans, respectively. Relative spread values obtained through the above methodologies were then aggregated and asset-weighted (by year) to obtain the overall spread value indicated in the piece.
Unless otherwise stated, all figures and estimates provided have been sourced internally and are as of March 31, 2020. Unless otherwise noted, all references to “$” are in U.S. dollars.
Nothing in this paper should (i) be construed to cause any of the operations under SLC Management to be an investment advice fiduciary under the U.S. Employee Retirement Income Security Act of 1974, as amended, the U.S. Internal Revenue Code of 1986, as amended, or similar law, (ii) be considered individualized investment advice to plan assets based on the particular needs of a plan or (iii) serve as a primary basis for investment decisions with respect to plan assets.
This document may present materials or statements which reflect expectations or forecasts of future events. Such forward-looking statements are speculative in nature and may be subject to risks, uncertainties and assumptions and actual results which could differ significantly from the statements. As such, do not place undue reliance upon such forward-looking statements. All opinions and commentary are subject to change without notice and are provided in good faith without legal responsibility.
Unless otherwise stated, all figures and estimates provided have been sourced internally and are current as at the date of the paper unless separately stated. All data is subject to change.
No part of this material may, without SLC Management’s prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient.
Past results are not necessarily indicative of future results.
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