Alternative credit: The next big portfolio building block?

Tune into our webinar on alternative credit

In today’s low-yield environment, we believe the various forms of alternative credit – distressed debt, structured credit and direct lending – deserve to play a major role in investment portfolios. In fact, we think alternative credit could become the next big portfolio building block.

Last Friday we held our webinar on alternative credit. During this webinar we discussed how alternative credit – distressed debt, structured credit and direct lending – deserve to play a major role in investment portfolios. In fact, we think alternative credit could become the next big portfolio building block. You can watch the webinar on demand.

Direct lending: attractive yields for long-term investors

In the final blog in this series, we focus on the benefits of direct lending – another attractive source of yield within the alternative credit market.

What is direct lending?
Direct lending involves investors other than banks directly providing private loans to medium-sized firms. The firms receiving the loans either use the money to grow organically or to fund acquisitions. 

The direct lending market has grown considerably since the global financial crisis, after which banks were hit with stringent regulations governing how much capital they could lend, and looks set for further expansion.

Direct loans’ typical characteristics
Direct loans generally have a legal maturity of 5–7 years, but companies often choose to pay them off earlier. They tend to be senior in the capital structure, so in the event of a possible bankruptcy, the direct lender will be at the front of the queue of creditors. What’s more, lenders generally insist on various covenants that set out certain conditions the borrower must meet, most often about how much leverage the firm can take on. 

The direct loan market is private and non-rated, but is on average equivalent to non-investment-grade corporate bonds in terms of credit quality. Most of the direct lenders that Kempen invests with provide credit to firms in sectors that provide stable cash flows rather than cyclical sectors such as shipping and retail.

Bergman Clinics: a case study
The Bergman Clinics, a Dutch chain of medical clinics, is a great example of a firm that’s grown strongly with the help of direct loans. It started out in the 1990s in the Netherlands as a small cosmetic surgery. Bergman went on to merge with a number of other clinics in the Netherlands (today it has a total of 70) involved in areas including eye surgery, orthopaedics, gynaecology and gastroenterology. In 2019 Bergman took over Memira, a market leader in eye care in Scandinavia with 50 clinics, and more recently it acquired six clinics specialising in vein and eye care in Germany. In each of these recent deals Bergman used money provided by the same direct lender, which has become a long-term partner to the firm.

Direct loans: the pros and cons
The most obvious advantage of investing in direct loans at present is the yield they provide: currently around 5–7% in what is a very low-yield environment¹. What’s more, as direct lenders originate the loan themselves rather than a bank, they earn an origination fee. This is typically between 2–3% and forms part of the return earned by investors.

Just like most other forms of alternative credit, direct loans pay floating-rate coupons, which means they could be a great option for investors concerned about an upturn in interest rates.

Compared with investments in traditional high-yield bonds or leveraged loans, direct lenders are often closer to companies’ management teams. They tend to have more control over the firms they lend to, especially when they are the lead or sole lender. As companies often have stringent information obligations towards direct lenders, the direct lender will know about all relevant developments at the company in a timely fashion and can react accordingly if necessary. And in the unlikely event of a default, direct lenders can take control of a company. What’s more, the top-tier direct-lending managers’ historic recovery rates have been higher than those achieved in the capital markets.

But investing in direct loans isn’t for everyone. They are illiquid, with investors’ money in principle locked away for up to seven years as they are not tradeable. That means investors need to do a lot of research to ensure they’re lending to firms that will be able to pay back the money they’ve borrowed.

Incorporating ESG
Direct loan portfolios lend themselves to ESG investing, and at Kempen we integrate ESG throughout our investment process. 

First, we urge our direct lending managers to exclude firms involved in areas such as controversial weapons, coal, tobacco and child labour from our investment universe. From there we screen all the managers we invest with for their ESG policy, such as whether they’ve signed the UN PRI. We also make sure they evaluate the firms they lend to based on ESG criteria and engage with them to drive positive change. 

Considering ESG risks is particularly important when investing in direct loans given their illiquid nature. Since we’re exposed to these loans for many years, we want to make sure they involve limited ESG risk. As these risks can potentially have a material impact on the long-term financial performance as well.

A good time to invest
Direct loans are a growing asset class and offer attractive long term investment opportunities. In our view, now’s a good time to invest in direct loans from a risk-return perspective. Because of the pandemic, banks have become even more reluctant to provide credit. That means more firms are turning to direct lenders to provide the loans they need, and are prepared to pay slightly higher yields at better terms for it. 

This article is written by Theo Nijssen

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  1. Source: Kempen, average portfolio yield of the direct lending managers Kempen invests with over period 2017-2020.

Disclaimer

Kempen Capital Management N.V. (KCM) is licensed as a manager of various UCITS and AIFs and authorised to provide investment services and as such is subject to supervision by the Netherlands Authority for the Financial Markets. 

This document is prepared by the fund managers of European Direct Lending Pool (‘the Strategy’), managed by Kempen Capital Management N.V. (‘KCM’). The Strategy might hold position in the subject company. The views expressed in this document may be subject to change at any given time, without prior notice. KCM has no obligation to update the contents of this document. As asset manager KCM may have investments, generally for the benefit of third parties, in financial instruments mentioned in this document and it may at any time decide to execute buy or sell transactions in these financial instruments. 

This document is for information purposes only and provides insufficient information for an investment decision. This document does not contain investment advice, no investment recommendation, no research, or an invitation to buy or sell any financial instruments, and should not be interpreted as such. The opinions expressed in this document are our opinions and views as of such date only. These may be subject to change at any given time, without prior notice.

 

Structured credit: a compelling risk-reward proposition

In our last blog, we took a look at the potential benefits offered by distressed debt – a high-risk, high-return segment of the alternative credit market. This time we turn our attention to structured credit, which is a lower-risk area but one that is still providing much higher yields than traditional bonds at present.

What is structured credit?
Structured credit consists of a range of fixed-income securities backed by various types of loans and mortgages, many of which are linked to consumers. At Kempen we allocate to four different parts of the structured credit market: residential mortgages, commercial mortgages, consumer loans and leveraged loans.

Some compelling reasons to invest
The percentage of bonds in the global fixed income markets currently providing a yield above 1% is very low. Structured credit yields are far higher. At Kempen, we invest across the structured credit markets to produce a portfolio that’s yielding 4–5% at present¹ – despite its high average credit rating of BBB+. To put that into perspective, a similar traditional US corporate bond would have a spread of around 125bp at the moment². 

Due to the nature of its underlying exposure – like exposure to private individuals - structured credit can represent a useful source of diversification in an existing bond allocation. Another benefit is that it generally has no interest rate sensitivity due to its floating-rate nature. Many investors are concerned about an eventual return of inflation, but they don’t need to worry when allocating to this asset class as its coupon payments will rise in line with inflation.

Strong consumers mean further strong performance potential
After suffering badly in the turbulence of last March, structured credit has performed well – its current yield of 4–5% is lower than it was in the spring³. But we don’t think it’s too late to invest. 

Yields of other bonds are so low because of quantitative easing measures, but central banks didn’t buy structured credit so its yields are undistorted. What’s more, the consumers that structured credit is linked to generally used last year’s government handouts to pay down their debts, so we believe they’re in good shape for 2021. This makes structured credit yields look highly attractive for the level of risk the asset class involves.

Case study: solar ABS – helping with the energy transition
A relatively new area of the structured credit market but one that’s growing rapidly is solar asset-backed securities (ABS). 

Lots of people have been looking to reduce both their energy bills and their carbon footprints by installing solar panels on the roofs of their homes. But doing so isn’t cheap. 

They often don’t want to or can’t afford to pay for the panels upfront, so they take out a loan that they pay back in monthly instalments instead. 

Several firms offer these loans, and it’s possible to invest in these receivables via the ABS market. Doing so provides a number of benefits for investors. Of course it means helping the transition towards a low-carbon world, and the loans provide exposure to the strong US consumer. What’s more, the bill for paying back solar panel loans is viewed as a utility bill, which means it’s a high priority payment obligation that people can’t skip payments on easily.

A good long-term investment
Structured credit does involve some drawbacks: it’s relatively illiquid, it can suffer sharp sentiment-driven drawdowns like in March last year, and it’s more complex than traditional bonds. 

But we believe it’s still a compelling proposition for long-term investors able to weather short-term volatility, and that the attractive yield it’s providing more than compensates for its illiquidity and complexity.  

This article is written by Remko van der Erf 

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  1. Source: Kempen, yield of Diversified Structured Credit Pool was 4.4% per 30-Nov-2020
  2. Source: Citigroup, 125bps is credit spread on BBB USD Corporate Bonds per 8-Jan-2021
  3. Source: Kempen, yield of Diversified Structured Credit Pool peaked at 8.4% in 2020 per 31-Mar

Tune into our webinar on alternative credit

To find out more about the benefits of structured credit and those of other alternative credit asset classes, please register for our webinar on 5 March.

5 March 12.00 CET

Disclaimer

Kempen Capital Management N.V. (KCM) is licensed as a manager of various UCITS and AIFs and authorised to provide investment services and as such is subject to supervision by the Netherlands Authority for the Financial Markets. This document is for information purposes only and provides insufficient information for an investment decision. This document does not contain investment advice, no investment recommendation, no research, or an invitation to buy or sell any financial instruments, and should not be interpreted as such. The opinions expressed in this document are our opinions and views as of such date only. These may be subject to change at any given time, without prior notice.

Distressed debt: the perfect time to invest?

With yields on traditional bond investments at all-time lows, now might be the perfect time for investors to branch out into distressed debt. Let’s take a look at why.

What is distressed debt?
Distressed debt consists of corporate bonds trading at a significant discount to par, either because a firm has entered bankruptcy or the market believes that bankruptcy is inevitable. Firms that get into financial difficulties see their bond prices slump as investors in traditional bonds sell.

Investors in distressed debt are willing to allocate to these cheap bonds and lead the financial and operational restructurings necessary to get the company up and running again. Distressed debt investors need a long horizon as turning around a company’s fortunes can take several years, but their investments can be highly lucrative.

Frontier communications: a case study
What does a distressed debt investment look like in practice? Let’s consider Frontier Communications, a US telecom company. It grew through acquisitions, buying parts of AT&T Telecom and Verizon, assuming it would generate enough profit to pay down the debt. But it didn’t, and could no longer invest in its network like its competitors. So its network was of poor quality, it started losing clients, and it had to file for bankruptcy. 

Thanks to distressed debt investors, it’s now set to re-emerge from bankruptcy. It will have to roll out fibre in the 29 states in which it’s active, and once it’s done that it can go about attracting new customers again. This will all take years, but it’s a visible plan – investors can work out how much money it’s likely to make and the resultant investment returns.

Plenty of opportunities to incorporate ESG 
Distressed debt investors are well placed to drive positive change: there can be much more scope to improve the ESG profile of companies in bankruptcy than of firms that are doing well. 

Let’s consider Pacific Gas & Electric in California, which went bankrupt after being forced to pay out billions in compensation for its role in starting wildfires in 2017 due to poor safety practices. Its distressed debt investors wanted to make sure safety issues wouldn’t crop up again, so they hired a chief safety officer, a chief risk officer, made it much more socially responsible, and the firm is now playing a major role in the move to renewable energy that California is renowned for.

Meanwhile, major European car-hire firms that are in a distress are using the opportunity to sell some of their existing fleet and move to electric vehicles. 

What’s more, from a social perspective, the very process of restructuring rather than letting a firm enter liquidation saves thousands of jobs.

Why invest now?
Distressed debt is a highly cyclical strategy. There aren’t many opportunities to invest in distressed companies when the economy is doing well, but after a recession there are lots, and big returns can be made.

The coronavirus pandemic could make it the perfect time to invest in distressed debt. The number of bankruptcies is likely to pick up in 2021, leading to fertile hunting ground for distressed debt investors. They’ll step in when they see a path for a firm to recover or when debt prices fall below the liquidation value of a company’s assets.

What’s different this time around is that Covid has hit some very strong companies. Even previously healthy firms in good sectors such as cruise lines have been hit hard. Normally only troubled companies in challenged sectors enter the distressed universe, but cruise lines had market caps in the tens of billions, operate in an industry with high barriers to entry, have lots of pricing power and are going to be highly popular options for holidaymakers once travel bans are lifted.

Historically, distressed debt has been a great investment after a crisis: we’ve calculated it’s returned above 15% per year in the three years following previous crises¹. Returns might be slightly lower this time due to the low risk-free rate and the huge amount of money in the system available to save companies due to stimulus, but we believe it could still provide 10–12% per year in the coming years².

This article is written by Remko van der Erf 

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  1. Source: HFR, Average annualized returns of HFRI Event Driven Distressed/Restructuring Index pre and post 7 crises: 1990-1991 recession, 1997-1998 Asian financial crisis, Dotcom bubble (2000), 9/11 aftermath (2002), Great Financial Crisis (2008), Euro crisis (2011), Energy crisis (2015-2016).
  2. Source: Kempen, expectations based on proprietary analysis, January 2021

Tune into our webinar on alternative credit

At Kempen we believe that now could be a great time to invest in distressed debt. To find out more about its benefits and those of other alternative credit asset classes, please register for our webinar on 5 March here.

5 March 12.00 CET

Disclaimer

Kempen Capital Management N.V. (KCM) is licensed as a manager of various UCITS and AIFs and authorised to provide investment services and as such is subject to supervision by the Netherlands Authority for the Financial Markets. 

This document is prepared by the fund managers of Diversified Distressed Debt Pool (‘the Strategy’), managed by Kempen Capital Management N.V. (‘KCM’). The Strategy might hold position in the subject company. The views expressed in this document may be subject to change at any given time, without prior notice. KCM has no obligation to update the contents of this document. As asset manager KCM may have investments, generally for the benefit of third parties, in financial instruments mentioned in this document and it may at any time decide to execute buy or sell transactions in these financial instruments. 

This document is for information purposes only and provides insufficient information for an investment decision. This document does not contain investment advice, no investment recommendation, no research, or an invitation to buy or sell any financial instruments, and should not be interpreted as such. The opinions expressed in this document are our opinions and views as of such date only. These may be subject to change at any given time, without prior notice.

 

The next big portfolio building block?

The past decade has seen a lot of changes in the financial markets. One has been the rise of alternative credit, an area where there are now lots of opportunities to be found. 
Alternative credit encompasses a number of different sub-asset classes, including distressed debt, structured credit and direct lending, and is an increasingly popular choice among investors.

Rooted in the great financial crisis
Like many market developments, the rise of alternative credit can be traced back to the great financial crisis. Banks were forced to become more careful about who they lent money to as regulators imposed stricter rules to make the financial system more stable and increase banks’ capital buffers. But companies still needed access to finance, leading other institutions such as pension funds to step in and provide the capital that companies need.

Two big benefits
Why has alternative credit become so popular among investors? We see two main reasons.

First, over the past few years the yields of traditional forms of fixed income have hit all-time lows, which means standard bonds are simply unable to provide the returns that many investors need. What’s more, with limited further upside potential, they’re no longer the safe haven that they used to be.

Investors have therefore been forced to look elsewhere. Alternative credit is a highly attractive option, providing a yield pick-up of 100–500bp1 relative to traditional forms of fixed income depending on the credit rating.

The fixed income universe of opportunities

 

Second, alternative credit provides good diversification benefits. Not only do its returns have a relatively low correlation with those of traditional bonds and equities, it also provides useful diversification of counterparties. That’s because it involves lending money to different kinds of borrowers, such as smaller businesses and households – something that isn’t possible with most other asset classes.

A sustainable option
With sustainability moving to the top of many investors’ agendas, it’s good to know that alternative credit provides plenty of scope to invest responsibly. Green bonds are increasingly being issued in several alternative credit asset classes, and sustainable benchmarks have been made available. It’s possible to exclude issuers with poor sustainability profiles and still build a balanced alternative credit portfolio.

Turn to an experienced manager

Alternative credit provides some compelling benefits, but of course it involves some potential drawbacks too. For example, it’s generally less liquid than traditional credit markets, and also more complex. 

That means finding the best opportunities requires a lot of time and expertise, which makes turning to a skilled manager very important.

This article is written by Michel Iglesias del Sol 

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  1. Source: Kempen, Jan 2021

Tune into our webinar on alternative credit

At Kempen we believe that alternative credit has a big role to play in portfolio construction, and could be the next big portfolio building block. To find out more about its benefits and our approach to managing the asset class, please register for our webinar on 5 March.

5 March 12.00 CET

Disclaimer

Kempen Capital Management N.V. (KCM) is licensed as a manager of various UCITS and AIFs and authorised to provide investment services and as such is subject to supervision by the Netherlands Authority for the Financial Markets. This document is for information purposes only and provides insufficient information for an investment decision. This document does not contain investment advice, no investment recommendation, no research, or an invitation to buy or sell any financial instruments, and should not be interpreted as such. The opinions expressed in this document are our opinions and views as of such date only. These may be subject to change at any given time, without prior notice.