Update Magazine I/2021
Higher yield potential as global rates slide after Covid-19 pandemic
Summary
For years, institutional investors have been struggling with the ongoing challenge of generating sufficient investment returns amid historically low interest rates. That challenge became even more acute as a result of policy actions taken during the Covid-19 pandemic, which prompted leading central banks globally, such as the US Federal Reserve and the Bank of England, to commit to keeping interest rates near zero for the foreseeable future.
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Update Magazine I/2021 |
1 Introduction
In essence, given recent market dislocations that have jangled the nerves of many investors, rock-bottom yields and bouts of elevated volatility, investors need investments that can deliver more returns for each unit of risk. While there is no silver bullet to solve this conundrum, we believe one asset class is especially well-suited for this challenge: Asia private credit.
The asset class offers attractive current income and potential long-term returns, with low correlations to public equity and corporate fixed-income markets broadly, and to Asian equities (MSCI APAC ex Japan) and Asian high yield (JACI HY) in particular. While low correlations do not insulate Asia private credit from market swings, certain characteristics that are unique to the region can help manage volatility.
Specifically, a corporate-credit supply imbalance for middle market companies in Asia allows private credit lenders to obtain stronger covenants and other protective structures that can help manage risk. This imbalance also facilitates a potential yield pick-up that can bolster returns that are already enhanced by Asian economic growth rates that have historically been significantly higher than in other markets.
As we will highlight in this paper, this supply/demand imbalance has deep, structural roots that are likely to persist, creating an attractive long-term investment case in Asia private credit for investors seeking to optimise portfolios.
A/ DEMAND FOR ASIA PRIVATE CREDIT IS DRIVEN BY DEMOGRAPHICS AND RAPID ECONOMIC GROWTH
GDP per capita forecast CAGR (2021–2025)
As of October 2020. Note: EM Asia ex-China includes India, Indonesia, Malaysia, Philippines, Thailand and Vietnam. Developed Asia includes Australia, Hong Kong, Japan, Korea, New Zealand, Singapore and Taiwan
Source: IMF World Economic Outlook (October 2020)
B/ DEMAND FOR CORPORATE LOANS IN EM ASIA EX-CHINA IS TRENDING HIGHER
Diffusion index (50 = neutral, above 50 = increasing demand, below 50 = declining demand)
As of November 2019. Note: EM Asia ex-China includes India, Indonesia, Malaysia, Philippines, Thailand and Vietnam.
Source: IIF
2 Taking advantage of an imbalance in supply and demand
Asia private credit is not like private credit elsewhere. In recent years Asian middle-market firms have grown rapidly, powered by economic growth rates that top developed Western economies by a wide margin. As shown in Chart A/, GDP per capita growth in emerging market Asia (ex-China) through 2025 is projected at almost double the rate for North America.
Since 2015, sustained corporate and economic growth in emerging Asia has created strong and accelerating demand for corporate loans (see Chart B/).
However, in Asian countries (excluding China), supply has failed to keep pace with mounting demand, leaving middle-market firms struggling to obtain the credit needed to satisfy their business plans. Chart C/ illustrates just how meagre the supply of credit is for non-financial companies in several Asian countries, relative to supply in other parts of the world.
There are structural causes for this variation in corporatecredit supply. China leads the world in corporate credit as a percentage of GDP because the government uses credit availability as a policy tool, making it an outlier that is not germane to our discussion. By contrast, in the US and Europe, market forces rule and, as a result, over the past decade there has been an abundance of middle-market credit. Banks are the traditional providers of loans, and that supply has expanded with the growing popularity of collateralised loan obligations (CLOs), Business Development Companies (BDCs) and Private Credit funds, adding significantly to credit supply.
Asian companies outside of China have far fewer options. CLOs and business development companies are nonexistent in Asia. Traditional corporate funding solutions, such as syndicated loans and high-yield bonds, are typically available only to large-cap firms in Asia. Private equity, increasingly important in the West, has grown in Asia in recent years, however, many middle-market firms are still owned by founders who are often loath to dilute their equity ownership
The lack of funding alternatives leaves middle-market Asian companies heavily reliant on bank loans. However, since 2008, global banks that had been one of the major providers of capital to Asian companies have deleveraged and significantly retrenched from Asia. The scale of that
C/ LEVERAGE BUILD-UP IN ASIA OUTSIDE OF CHINA HAS BEEN MODEST
Diffusion index (50 = neutral, above 50 = increasing demand, below 50 = declining demand)
As of April 2020. Note: EM-30 includes Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Ghana, Hong Kong, Hungary, India, Indonesia, Israel, Kenya, Lebanon, Malaysia, Mexico, Nigeria, Pakistan, Philippines, Poland, Russia, Saudi Arabia, Singapore, South Africa, South Korea, Thailand, Turkey, Ukraine and United Arab Emirates
Source: CEIC Data
pull-back is evident in Chart D/, which illustrates claims of global banks on Asian banking assets, down to 28% in 2020 from 40% in 2009. At the same time, these banks no longer offer structured credit solutions to Asian companies.
Meanwhile, high loan-to-capital ratios constrain the lending capacity of local Asian banks. In the West, credit supply is expanded significantly by the ability of banks to access wholesale markets to fund loans far in excess of their deposit bases. Such wholesale markets are not widely available to local banks in Asia. Since these banks are approaching, and in some countries exceeding, 100% loanto-deposit ratios (currently 89%),2 they are rationalising their available credit and directing it to their market’s biggest and potentially most profitable companies, leaving little funding capacity for middle-market borrowers.
The intersection of vigorous corporate growth and constraints on credit availability create a corporate-credit supply/demand imbalance that has given rise to some unique conditions that can work to the advantage of investors in Asia private credit.
3 Unique traits benefit lenders and investors
Some of the advantages created by these unique supply-demand dynamics are obvious. For starters, with credit in short supply, lenders can charge higher interest rates, leading to potentially higher yields for investors (yield ranges for Asia private credit are discussed in more detail in the next section of this paper). In addition, the scarcity of credit supply (see Chart E/) acts as a natural regulator on the leverage of Asian companies.
D/ GLOBAL BANKS EXTEND LESS CREDIT TO ASIAN
MIDDLEMARKET FIRMS THAN A DECADE AGO
% of total cross-border claims on Asian banking assets
As of June 2020. Source: World Bank, Bank for International Settlements, broker research
E/ LENDING CAPACITY OF BANKS IN ASIA IS CONSTRAINED
Loan-to-deposit ratios across Asia (2008 vs Q2 2020)
As of June 2020. Source: World Bank, Bank for International Settlements, broker research
Benefits of Asia private credit include
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Asia private credit offers the potential for superior longterm risk-adjusted returns. We believe that, when properly managed, investors could see a potential pickup of 75 basis points per unit of leverage over fixedincome alternatives, including the potential for steady cash incomes between 5% and 7%, with comparatively lower volatility.
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The lack of supply allows lenders to demand stringent covenants and other controls. In the US, the availability of ample credit made available from banks to BDCs has created a buyers’ market marked by increasingly lenient loan covenants. First-lien “covenant-lite” loans now make up the majority of North American leveraged loans, according to Moody’s.3 These weakened covenants mean “that leveraged loan documentation offers limited protection to institutional loan investors [in North America].”4 This dynamic is largely reversed in Asia. With corporate credit demand outstripping available supply by a wide margin, borrowers in Asia lack the leverage to negotiate terms. As a result, loans are typically “covenant-heavy”, usually including conditions related to liquidity, net worth, information rights, reserved matters and stipulations that give lenders control in important areas, such as mergers and acquisitions and dividend payments. Such restrictive covenants, now rare in the US and other Western markets, give lenders and investors in Asia private credit valuable protections.
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The supply shortage of corporate credit in Asia can allow lenders to secure additional protections, such as board seats and personal guarantees, that are rarely available in other markets. For credit providers, board seats represent a valuable forward-looking window into the borrower’s finances and operations, providing real-time early warnings of problems, and a chance to influence operational responses to challenges. By contrast, in western markets, lenders often learn about borrower problems only in retrospect.
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Many middle-market firms in Asia are still owned by founders who are often willing to sign personal guarantees on loans that provide their companies with much sought-after solution capital. Such guarantees are virtually unheard of elsewhere.
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Protections such as strong covenants, personal guarantees and board seats have a direct impact on loan loss rates and, therefore, on the overall performance of loan portfolios. Between 2014 and 2019, Asian public corporate high-yield debt defaulted at at annual average rate of 1.8%, slightly above Europe (1.5%) and well below the US (2.7%). During the same period, public corporate high-yield recovery rates in Asia were 53.2%, better than was the case in Europe (39.8%) and the US (36.7%).5 Although default rates on private credit are not widely available, in our experience default rates on Asia private credit are significantly lower than those reported for comparable public highyield bonds. In fact, defaults are rare in Asia private credit – at least for properly structured private loans. Furthermore, recovery rates on these loans have historically been high relative to those in US and European high-yield markets. Why? Because of covenants, board seats, personal guarantees and other protections, the relationship between lender and borrower tends to be much closer than in other credit markets. As a result, when loans run into trouble – and they do on occasion – companies typically have a greater incentive to avoid default, and instead work with lenders towards a cooperative restructuring, or an “amend and extend” scenario. Frequently, this entails some repayment or other steps aimed at improving credit quality, a modification that can decrease the internal rate of return, but is designed to increase the multiple on capital.
F/ ASIA’S REGULATORY/LEGAL ENVIRONMENT IS IMPROVING
As of 2019. Note: the strength of legal rights index measures the degree to which collateral bankruptcy laws protect the rights of borrowers and lenders, thereby facilitating lending.
Source: World Bank
4 Creditor rights are improving across Asia
Creditor rights in Asia are now almost on a par with global standards (see Chart F/). Although each country in Asia has its own regulations and bankruptcy framework, and each exists along a continuum of sophistication, the regional trend has been improving. That trend is reflected in the World Bank’s legal rights index, which measures the degree to which collateral and bankruptcy laws protect the rights of borrowers and lenders.
Tier 1 countries in Asia (Australia, India, Indonesia, Singapore and Vietnam, which together constitute 70–75% of the Asia ex-China market) are all above or closing in on the average legal rights score of OECD countries. For example, India improved its score – from 6.0 in 2013 to 9.0 in 2019 – due to the country’s recent reforms and its Insolvency and Bankruptcy Code, passed in 2016.
5 An advantageous risk-return profile
The unique conditions and characteristics described in this report create a risk-return profile for Asia private credit that diverges from private credit markets in Europe and North America. As a result, Asia private credit can provide some important benefits that could positively impact an institutional portfolio.
The first of these benefits is, as noted earlier, the potential for superior long-term risk-adjusted returns (as a result of the combination of potentially higher yields and steady cash incomes) with comparatively lower volatility.
Allocations to Asia private credit may also add diversification. For example, by investing only in middle-market firms and excluding those in China, an investor could add diversification relative to developed market and emerging market approaches, which tend to be heavily weighted to large-caps and firms in China. This focus would not be limiting. The Asian market represents 70% to 80% of global EM opportunities. The large and diverse investable universe in Asia outside China provides ample opportunities to invest throughout the credit cycle.
Furthermore, because these loans are private, investors in Asia private credit have proprietary access to a diversified set of cash flows that are simply not available to other investors. This is a crucial point: one of the main reasons Asia private credit provides such attractive benefits is that it has high barriers to entry, limiting competition for deals, and affording established providers powerful leverage when negotiating loans. Middle-market lending in developing economies can be a risky proposition if not done correctly. To succeed, we believe that investors need significant capital, access to deals, specialised credit/lending skills and on-the-ground presence.
Asia private credit can deliver enhanced risk-adjusted returns and other important benefits to insurance companies and other investors, at a time when such outcomes are badly needed.
6 Mitigating currency risk
Most direct corporate loans made within the Asia private credit asset class are issued in US dollars. This largely removes foreign-exchange risk for investors.
A manager might on occasion make unhedged local currency investments to back particularly attractive growth capital opportunities that cannot be accessed in US dollars for regulatory or market reasons, or when the local currency is more appropriate for the strategy’s risk/return profile.
India and Australia are two regions where investors can expect to see investments in local currency. However, even within these countries, a manager might only agree to local currency exposure for investments that meet strict criteria. For example, local currency loans could be made in cases where that exposure improves the enforceability of security and lender rights, reduces funding costs, or improves the credit profile of the investment in terms of better matching asset/liability cash flows.
In these instances, a manager can pursue various means to hedge currency risk, including:
- Direct currency hedges using forwards and swaps
- Downside protection hedges using options
- Downside protection via shareholder indemnities
- Structuring currency make-whole provisions into credit agreements
To avoid substituting currency risk for credit risk in US dollar lending, a manager should employ rigorous fundamental analysis, including an examination of currency-related asset and liability mismatches, financial modelling and debt sustainability projections, and stress tests of local currency volatility and its impact on projected cash flow.
7 Conclusion
With central bank responses to the global Covid-19 pandemic pushing interest rates even lower, institutional investors are badly in need of opportunities designed to enhance overall portfolio returns at acceptable levels of risk. Asia private credit could represent just such an opportunity.
Asia private credit can deliver enhanced riskadjusted returns and other important benefits to insurance companies and other investors, at a time when such outcomes are badly needed. A portfolio allocation could potentially increase total portfolio volatility, but could also increase absolute return expectations, and improve the portfolio’s Sharpe ratio while also improving investment income, and reducing interest rate exposure through spread diversification.
Due to a shortage of credit for fast-growing middlemarket companies in Asia, investors can earn attractive yields, while simultaneously benefitting from protections such as relatively low corporate leverage rates, strong covenants and board seats, and personal loan guarantees from company owners. These unique characteristics serve to manage volatility, and potentially enhance longterm risk-adjusted returns.
2 World Bank, Bank for International Settlements, broker research, as of June 2020
3 Global Leveraged Finance: Market View, Moody’s, April 7, 2020.
4 Distress In The Leveraged Loan And CLO Markets Will Significantly Hurt Lenders And Investors, Forbes,
March 27, 2020.
5 J.P. Morgan. As of October, 2020.
Private debt investments are highly illiquid and designed for long-term professional investors only under the terms of the MiFID regulations.
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