Public and Private European Credit – where is the sweet spot?

The current macro environment is transforming the landscape for public and private credit investors. How do you see this developing? What implications are there for institutional investors from a risk-reward perspective?

David Zahn: We've seen central banks continue to hike rates, but we're getting closer to the end of this cycle. The market has not reacted in the way the ECB had expected, and the more they’ve hiked, the more the market has rallied. So, we think that rates will continue to go up and stay there for a while.

Overall, the economy seems quite robust. There is slow growth in Europe but in the US, we're seeing resilience. Whether there will be a recession is debatable, so credit seems to be a sweet spot for both public and private investors. And following last year’s selloff, public valuations look attractive.

Over the next couple of years, we favour investment grade on a risk-reward basis. Beyond that, we may get into another rate cutting cycle – but in Europe, that's probably at least 18 months away.

Howard Sharp: In private credit, we invest in floating rate loans so have benefitted from the base rate pick up. With spreads widening away from the artificial investing environment that we've been in for the last few years, we're now in a more dynamic risk pricing environment.

We’ve seen a growing mathematical need to reduce the amount of leverage in the system to deal with the cost. Another changing dynamic is that business owners are having to work harder to generate returns rather than just hope they can get a decent multiple from selling the business.

Right now, we can't really look beyond the next two or three years because everyone’s still adjusting to the new environment.

The denominator effect could cause investors to review their allocations to public and private credit. How do you see this evolving in the year ahead?

Howard: The denominator effect will hit some European pensions and insurers more significantly than others. This could cause some to review their allocations between public and private markets.

From a risk-return perspective, private credit is the most interesting it's been in years. However, allocations are being impacted as some investors are holding back due to current market dynamics.

As the lines between private and public markets become blurred in the current economic environment, we’ll have to wait and see how things unfold until the public markets come back with the strength that we expect.

David: Meanwhile, allocations are increasing in public markets because investors can get good yields. And if some investors think we're getting close to the end of the rate hiking cycle, they tend to prefer fixed rate assets to lock in the longer yields and some duration. This is likely to be a temporary effect over the next year or so. 

Public market lending tends to be to big companies and for large sums. For example, our minimum is US$300m to US$500m in a bond issued. Within private markets, the focus tends to be more on small to mid-size companies. This inherent diversification means investors can get exposure to a different part of the economy.

European public and private credit play different roles in investors’ portfolios. What are some of the key differences between them and how can investors use these to their advantage?

David: Overall liquidity is the big difference. There is also a different risk profile from lending to larger entities which have larger amounts of capital behind them. With private lending, you can exercise greater control over the company because the amount you’re lending is significant relative to the size of its balance sheet. In the public markets, you’ll have limited, comparative control. 

The other area that is interesting in the public markets is the focus on green and social bonds. Again, you have to be quite a large enterprise to talk about issuing a green bond for, say, US$300 million because you’ll need to have a bankable project to do that.

Howard: Liquidity is obviously the main difference. You need an illiquidity premium to be in private credit, and we calculate ours against the benchmark which is the Credit Suisse Western European Leveraged Loan Index (WELLI). We look at that, and then at ours, and calculate a through-the-cycle 300 basis point premium to the Credit Suisse index. We think this is what investors look for if they're locking up their capital for longer.

Right now, private credit is stepping into the gap that's been left by liquid market investors to provide capital for mid to upper-sized businesses. In contrast, the broadly syndicated loan market is a covenant-lite market meaning it deals with bigger companies. The additional measure of control and covenants are important considerations based on our conversations with investors.

David: They're both good markets to be invested in, it's just that they do different things. With public markets, you're getting your beta and the longer duration asset, whereas private markets are still not as well understood by the general marketplace so they tend to generate greater alpha.

Howard: The percentage that investors are allocating to private credit is growing, but it's in the alternatives bucket. The public bond market is always going to provide the larger overarching percentage of credit that investors are looking for to meet some of their goals like liability matching.

How do you view the opportunity in European credit vs US and other regions?

David: Europe is far cheaper than the US. Over the last decade, we saw large flows going into the US when the dollar was strong, and hedging was cheap. Now hedging is expensive; it costs about 2% to hedge dollar assets back to Europe. European investors are realising they can get the returns they want in European credit markets and dollar investors are now also interested in Europe. The European high yield market is very much a BB market, so it's high quality which gives good yield pick up compared to the US.

The central bank reaction is also quite different. Historically, the European Central Bank doesn't like to have recessions, whereas the Fed is at a point where they might be a little bit more tolerant of recessions. This can be supportive of European credit.

Howard: For a dollar investor looking at private credit, spreads and fee levels are broadly aligned between Europe and the US. After hedging, you're coming out with similar levels of return. Investing away from the US can also offer a diversification benefit.

In addition, the markets are quite different. The European private credit market is about a decade old, while the US market is about 30 years old and is becoming somewhat more commoditized. Europe is still largely a ‘bilateral relationship’ market with lenders being the sole lender with financial covenants and bespoke documentation. The US has become more ‘cove-lite’ by contrast. So, investors can blend their market allocations depending on the risk profile they prefer.

Thinking on a sector basis, where do you see the risks and opportunities?

Howard: The private credit market is increasingly focused on lending to business to business (B2B) sectors. This market grew out of the withdrawal of the banks in the leveraged lending space. It has coalesced around sectors like healthcare, business services, software, and digital media. With B2B, the borrower tends to have a corporation as its client rather than the end consumer. These tend to be businesses with lower capex requirements and energy costs.

The US market has 20 years more experience, and the bank market is pretty much non-existent, so it covers a wider range of sectors. With that comes the potential for higher default rates in certain sectors.

There’s a general consensus about the fact that the level of defaults this year will be higher than in previous years. That’s obvious given that for the last few years, we've been working in this artificial environment in terms of low interest rates and relatively lower margins.

David: Many of the companies involved in the public markets – utilities, autos, cement, steel – are in traditional industries. They also tend to have massive capex requirements which translates into higher borrowing costs. Borrowing requirements are also linked to the support they need in their energy transition.

On that front, investors can have a good amount of engagement with larger, older, public companies on these topic areas whereas we find that smaller companies are not as focused on this yet. There is clearly a strong focus on transitioning in the public market, for example green bond issuance can be five or six times oversubscribed.

Howard: I agree. The sectors David mentioned lend themselves to the public markets very well because it’s a liquid market allowing you to trade out of the risk if need be. Private lenders look for companies that will be resilient through a cycle. These tend to be in sectors that are based around people rather than assets, with medium- to long-term contracts embedded with their corporate clients.

David: The markets are each useful for different investment time horizons. With private markets, you invest until maturity and with public markets, you’ll have a two-year view of how you think it’ll do. If you buy a 10-year bond, it's unlikely that you’ll still own it when it matures. Investors can balance each depending on their appetites for duration and risk.

As investors look to increase their duration exposure, how should that play out in terms of their public and private allocations?

Howard: This is a key consideration for different investor types. Typically, funds in our market are six-to-ten-year life funds investing in assets that are six to seven years contractually. But the average life loan recently has been around three years because shareholders have been recycling those assets on a three-year basis.

The cost of debt going up has had an impact on multiples, resulting in enterprise value compression and less willingness to sell on a three-year cycle. Holding an asset for, say, four to six years rather than three is returning to something we've seen within private equity in the past, indicating a slight normalisation.

David: In the public markets, there is an overall desire to lengthen duration by all investors. They all have been underweighted or haven’t owned fixed income for years. This varies depending on the individual client. Some institutional clients that have been holding cash now want to go into short duration assets. But for pension funds and insurance companies, they may want to do the opposite and go into that 10 year plus sector where you can lock in returns.

After last year’s big equity market selloff, investors perceive that the returns are a bit more certain in fixed income because they know what the yield will be plus or minus some capital appreciation or loss. Whereas with other asset classes, it's more difficult to pinpoint what your return will be. So, there's more of a focus on simply increasing exposure to fixed income assets.

Another major risk in Europe is the energy crisis. Do you feel that we’re through the worst of it now, or should investors still be wary as we approach next winter?

Howard: While we have concerns about the cost of energy, wage increases and the ability to pass those on are more relevant in our market as we are dealing mostly with people-based economies. 

David: The main risk we see is how easy it’ll be to get gas storage inventories full again once winter’s over. Last year, there was still Russian gas flowing in the first half of the year.

There's a big discussion over whether this means the greening of Europe has been pushed or is even dead. We don’t think it is. In fact, it’s our view that longer term, we'll be far further along with the greening of Europe than if we hadn't had this energy crisis. So, you’ll see a lot more investment into renewables, solar, wind, geothermal, and nuclear. The energy mix will change significantly.

Sustainability, and more precisely a focus on carbon reduction, is a key goal for European investors. How do you tackle that in your investment process?

Howard: Private markets have taken public markets’ lead here and investors are demanding this. All of this means article 6 funds will find it increasingly difficult to raise capital. We see growing interest in impact strategies, typically article 9 funds. But also there’s growing interest in ESG favourable funds that will align more with article 8 which is our approach.

For our most recent private credit portfolio we are targeting that at least 50% of it promotes certain environmental and social factors. That said, it’s really our goal to have 100% of our portfolio doing that. We work with companies to include ESG targets in their financing agreements. Examples could include a company turning their fleet of vehicles from diesel to electric vehicles, with stretching targets year after year in return for a reduction in the cost of their financing. This sort of approach would be tailored to each company. Smaller companies don't necessarily have the teams and expertise to know how best to do this and so we’d be on hand to help them with that.

David: In addition to exclusions, the biggest change in our process has been the introduction of a focus on carbon reduction that analyses corporates and sovereigns separately. This enables us to remove the top one-fifth of emitters in each industry from our investment opportunities. While we don't invest in laggards, we look to see if they have science-based targets and how they’re doing in terms of achieving them. We can invest and support companies like this if we see that they have high ambitions.

The other area we focus on is green and social bonds. In most of our conventional strategies, we have about 20% in green and social bonds for the sustainability focus. When we're looking at the green bonds, we look at the overall company’s decarbonization drive not just the project we’re funding. So, the overall focus of our strategies is on decarbonising and doing it in a constructive way.

Interviewed by David Brannon, Head of Research, Savvy Investor.

This material was originally published in the Savvy Investor Special Report: Discovering Sources of Alpha and Diversification in Fixed Income: Industry experts discuss opportunities in a transformed fixed income landscape.