Private Debt: Higher Returns Without Higher Risk

Private Debt: Higher Returns Without Higher Risk

By Don Bangay, CFA, Managing Director, Integrated Private Debt

The investment grade private debt market enhances the performance of institutional fixed income portfolios with a predictable, sustainable and easy-to-understand combination of higher rates of return and lower risk than public market bonds. It is a traditional cash market that invests directly in the senior secured debt of businesses employing fundamental credit analysis and investment management processes to control risk and maximize return.

The private debt market is positioned between bank term loans and the public bond market. It is an attractive alternative to bank loans for investment grade borrowers who lack the size to access the public bond market or are private companies or have unique or unusual borrowing requirements. For investors, the private debt market provides the fixed interest rate/fixed term predictability of the public bond market combined with the stronger credit risk controls of the bank loan market that come from stronger covenants, collateral security and a direct relationship with the borrower.

Public bond market investors are disconnected from borrowers with highly specialized intermediaries (investment bankers, credit rating agencies, trustees, etc.) performing most of the direct risk management processes. In the private debt market, all the risk management processes, from the inception of the investment until it is repaid, are actively managed by an in-house team of specialist investment managers. The adage that “any fool can put money out, it takes skill to get it back” is a core value statement in the private debt market.

Credit risk is a proven source of sustainable premium rate of return in debt markets and a source of material performance enhancement for a fixed income portfolio. A yield pick-up of at least 200 basis points over Canada bonds is a reasonable expectation in the investment grade private debt market. This will result in a noticeable and repeatable improvement in fixed income relative performance. Also, with Canada bonds providing a real return of 2.0% and the private market yield pick-up of 200 basis points, the 4.0% real return on private debt exceeds the real return target for most pension funds.

The sources of higher interest rates in the private debt market are:

  1. Credit Risk – investing in the lower end of the investment grade scale is safer in the private debt market than in the public bond market because of the stronger covenants, active management and direct investor/borrower relationship.
  2. Illiquidity Premium – private debt is a buy and hold investment that is not intended to be traded.
  3. Market Inefficiencies – extra basis points of yield are obtained without additional risk from such features as custom designed loans, confidentiality, lower transaction costs, etc.

An important (and underappreciated) source of lower risk and higher realized return in the private debt market is the higher recovery rate on defaulted investments. Private debt market recovery rates are in the mid-80% range, much higher than the 38.4% recovery rate Moody’s reported for senior unsecured bonds in the 1982 to 2006 period. To put the importance of the higher recovery rate into perspective, the loss ratio in a 3.0% default scenario would be 0.45% for private debt, much lower than a 1.85% loss ratio experienced in the public bond market. The higher recovery rate in private debt is due to the strong covenants, the ongoing direct investor/borrower relationship and, in most cases, the objective of obtaining a “going concern” solution to defaults that restores the borrower to financial health.

In summary, the investment grade private debt market outperforms the public bond market because it starts with a higher yield and loses fewer basis points due to defaults resulting in a higher rate of return with a lower level of risk.

Transcontinental Media G.P.