Article
Private Credit: An alternative asset class to boost yields, lower volatility and diversify portfolios
March 9, 2023
Introduction
At Invesco, Private Credit encompasses senior secured corporate lending to a range of companies, including smaller capitalised middle market issuers and larger issuers that utilise loans as part of a broader capital structure. Our private credit expertise spans across different disciplines, including:
- Direct lending — Invesco directly structures and originates loans to leading and stable middle market companies.
- Broadly syndicated loans (BSL) — Invesco invests in loans to large US and European issuers whose debt is broadly syndicated to institutional investors. These loans are actively traded in the over-the-counter secondary market.
- Collateralised loan obligation (CLO) notes — Invesco invests in the AAA through BB-rated notes of CLOs, which are pools of broadly syndicated or middle market loans.
- Distressed credit — Invesco invests in loans and debt of stressed or distressed companies at significant discounts to par seeking to unlock upside potential.
Why invest in Private Credit?
Across all disciplines, the common focus is on senior secured corporate loans, which are:
- Private debt instruments – loans are not public securities. Because they are not public securities, corporate loans trade in the private markets.
- Senior secured – loans reside at the top of the capital structure and are secured by (in most cases) all of a company’s assets. This seniority often results in higher recovery rates in the event of stress, and can help to limit credit losses.
- Floating rate – floating rate coupons have little to no duration or interest rate risk, and benefit from rising rates with higher coupons.
These features make private credit, as a whole, very attractive in most environments (including today’s) given they offer:
- Consistently stable and high income
- Little to no interest rate duration
- Downside mitigation
The importance of senior loans
Senior loans feature across the private credit investment universe. These loans are privately arranged debt instruments comprised of below investment grade borrowers. They are positioned at the top of the capital structure and secured by the assets of the company. This enables senior loans to provide relatively high levels of income. They also typically feature floating rates.
Private Credit segmentation
- Like BSLs, direct loans are senior secured and floating rate but are smaller and made directly (no intermediary involved) to middle market companies.
- Direct lending loans are less liquid due to their smaller size and are typically held by a small group of lenders (< 5); as a result, direct lending is mostly a “buy and hold” strategy.
- At Invesco, we primarily focus on core middle market companies ($10-75 million EBITDA), which we believe offer consistent return potential while maintaining strong creditor protections.
- Investors are typically compensated with 200-300 basis points of additional yield above BSLs.
- Senior secured and floating rate loans are made to large cap companies and syndicated by intermediary commercial and investment banks. These loans are distributed to multiple institutional investors.
- This is the most liquid part of the Private Credit space as these loans are larger in size (typically >$500 million) and are actively traded across numerous market participants with daily mark-to-market pricing through multiple providers.
- BSLs are also attractive relative to other liquid debt markets like high yield bonds. BSLs offer higher yields with better downside insulation given their senior secured status and materially higher recovery rates (~60-70% for loans vs. ~30-40% for high yield bonds).
- While some BSL issuers may have public debt or equity, Invesco will mostly (but not in all cases) remain on the “private side” and have access to material non-public information as part of the private loan syndicate.
- A securitised version of BSL exposure, CLOs create portfolios of hundreds of loans and structure them into different tranches with different risk/return profiles.
- This range of risk/return profiles allows investors to choose their preferred balance of risk and return, while benefiting from a collateralised structure which has proven resilient over time.
- Typically, CLO notes offer a premium to other securitised vehicles because of the complexity of understanding the underlying private loans and uniqueness of each CLO structure.
- CLO notes are registered securities and trade and settle like bonds.
- Similar to direct lending, distressed credit is typically less liquid in nature, but can offer higher potential returns (with incremental risk).
- Distressed credit typically involves investing in the senior debt of companies at significant discounts to par – due to perceived fundamental weakness.
- Returns are generated by investing in companies where, over the longer-term and through various actions, meaningful upside potential can be unlocked.
- At Invesco, we take a proactive approach to value creation in seeking asymmetric return profiles – targeting equity-like returns with credit-like risk.
- We focus specifically on inefficient markets which tend to offer a more evergreen opportunity set and are less industry/cycle dependent.
- For institutional investors who make their own asset allocation decisions, choosing from the above single-sector private credit strategies likely makes the most sense.
- For those who prefer to blend the attributes of each sector, or who have custom risk/return targets, a multi-strategy private credit approach could be appealing.
- The multi-strategy approach combines two or more strategies within target exposure ranges.
- Furthermore, within this approach, a manager may be able to dynamically adjust allocations in anticipation of changing marketing environments (see Figure 2 example).
- For investors interested in multi-strategy private credit, it is often simplest to implement by partnering with an integrated private credit platform with all capabilities under “one roof.”
Figure 1. Profile of Private Credit
|
Direct lending |
Broadly syndicated loans |
Collateralised loan obligation notes |
Distressed credit |
|---|---|---|---|---|
Market size/opportunity set |
$1.0+ trillion |
$1.7 trillion |
$1.1 trillion |
NA |
Investment strategy focus |
Senior secured and floating rate loans made directly to middle market companies |
Senior secured and floating rate syndicated loans to US and European large cap companies |
Securitised portfolio of BSLs offering range of risk/return profiles from AAA to BB |
Senior debt investments made at significant discounts to smaller capitalisation companies that may have experienced stress |
Interest rate sensitivity |
Little to no duration or interest rate risk |
|||
Liquidity profile |
Less liquid; buy and hold (until refinancing/maturity) |
More liquid; actively traded |
Notes are securities that trade and settle like bonds More liquid; actively traded |
Less liquid; longer holding periods (until exit) |
Target return profile |
9-12% |
6%-11% |
2%-10% |
16%-20% |
Typical default, recovery & |
Historically materially lower default rate than BSLs |
Average default rate: 2.8% Average recovery rate: 64.4% Average default loss rate: 1.0% |
Triple A, double A and single A-rated CLO notes have never experienced a principal impairment
|
Not applicable, given investments can be made with the expectation of a default to unlock meaningful upside potential |
There is no guarantee performance targets will be achieved
Sources: Invesco; Research, Intex, LCD, IGM as of December 31, 2022 Credit Suisse LLI & Credit Suisse West Euro LLI as of December 31, 2022; Citi Research, Moody’s as of 12/31/2019 “Impairment & Loss Rates of U.S. and European CLOs: 1993-2019”, “Structured Finance - Global: Impairment and Loss Rates of Structured Finance Securities: 1993-2019”, “Annual Default Study: Corporate Default and Recovery Rates, 1920-2019”; JPMorgan as of 12/31/2022, based on 25-year average.
Figure 2. Allocation across private credit based on market environment
Source: Invesco
Why Invesco for Private Credit
Figure 3. Invesco Private Credit platform
30+ years
100+
200+
2,000+
| Invesco Private Credit platform | |||
|---|---|---|---|
| Direct lending | Bank loan group | Collateralised loan obligation notes | Distressed credit |
| Direct lending to middle-market companies | Broadly syndicated corporate loans in both the US & Europe | Securitised portfolios of syndicated loans in a variety of rated tranches | Opportunistic investments in stressed & distressed credit |
Source: Invesco as of December 31, 2022. $38+ billion indicates assets under management across Invesco's Private Credit platform.
Invesco Private Credit is one of the world’s largest Private Credit managers. Our investment professionals also have some of the longest tenures in the industry. The fundamental credit process we employ is both consistent and conservative. Our capabilities span senior loans, direct lending, CLO notes, and distressed credit.
Direct lending
- We have broad sector expertise and a large team. This allows us to source better deals and carry out enhanced due diligence.
- Invesco seeks to directly originate loans to middle market companies. We aim to generate strong risk-adjusted returns with lower volatility relative to traditional fixed income assets.
Broadly syndicated loans
- Invesco offers a suite of strategies focused on US, European and global opportunities that are distributed to retail, high net worth and institutional investors. These strategies are available as both unconstrained and ESG portfolios.
- As private-side investors, we have an informational advantage compared to our peers with deeper access to management teams and private information. Our size and scale mean we are among the first calls and receive preferential allocations on new deals that pass our stringent credit requirements.
Collateralised Loan Obligation Notes
- We manage portfolios of AAA to BB non-Invesco issued CLO notes in institutional separately managed accounts. We also launched a managed ETF offering focused on investing in AAA-rated tranches of CLOs.
- Focus on defensive positioning, liquid tradable portfolios, and seeking to capitalise on market dislocation.
Distressed credit
- Unlike traditional large-cap distressed strategies that are often dependent on market cycles, recessions or sector-specific shocks, we focus on idiosyncratic or company specific opportunities.
Invesco’s ESG capabilities within Private Credit
- ESG plays a critical role in Invesco’s credit underwriting process and is a key discussion factor in the investment team’s credit evaluation of potential investment opportunities.
- Invesco’s credit analysts spend a great deal of time getting to know borrowers’ management teams, sponsors, key suppliers and customers.
- Each corporate loan in the middle market and broadly syndicated loan space is independently measured by our credit analysts on 16 ESG risk factors.
- To date, Invesco’s bank loan analysts have conducted ESG diligence reviews and independently rated over 800 global issuers for ESG risk and inclusion in ESG portfolios.
Private Credit and the market cycle
Private Credit is seen as a robust option for a diversified portfolio regardless of the economic environment (Figure 4).
Whether it’s an inflationary environment or disinflationary, the asset class offers little to no interest rate duration risk given its floating-rate structure.
Private Credit offers a stable and high level of income, as corporate loans generally offer income potential above that of traditional fixed income, with incremental risk.
The senior secured nature of the assets also results in higher recovery rates than on subordinated debt and high yield bonds.
Although potential defaults are a risk, data shows that the actual default rates for senior loans undershoots the implied rate (Figure 5). This even holds true amid a volatile or recessionary economic climate, as brought to life by the below case study.
Case study
How senior secured loans performed during the Global Financial Crisis
Both the Europe Leveraged Loan Index and the US Leveraged Loan Index suffered a drawdown during the 2008 GFC. But that was offset within 12 months by a strong rebound, highlighting the robustness of the senior secured asset class. In fact, loans have only posted negative returns in three of the past 31 years as shown in the chart below.
In other recessionary periods – 2001 and 2020 – senior loans offered positive returns.
Figure 4. Resilience through full economic cycles and interest rate environments
Source: Credit Suisse Leveraged Loan Index through December 2022, updated anually. Past performance is not a guarantee of future results.
The sharp drawdown in 2008 was caused by a massive sell-off in the loans market. Many felt pressure to deleverage their portfolios after Lehman Brothers went bankrupt, resulting in this situation. There was also a serious overhang stemming from loans that had already been signed, but were still on bank balance sheets and hadn’t yet been syndicated.
Despite the sharp correction in 2008, two important observations can be made:
- Compared to other asset classes that also experienced heavy pressure, loans continued to pay highly stable cash flows.
- As this sharp drawdown was not really driven by corporate fundamentals, the mispricing was corrected again the following year.
Investors who were prepared to stick to a buy-and-hold strategy were rewarded.
Between January 2008 and December 2010, senior secured loans produced an absolute return of 4.38% p.a. and 3.69% p.a. for the US and Europe respectively. This was achieved despite a spike in defaults. That said, market implied defaults were much higher than actual defaults that materialised.
Figure 5. Historial actual vs implied defaults
Source: CS Leveraged Loan Index, Pitchbook LCD as of December 31, 2022. Implied default rate calculated by taking implied default loss (current spread –historical risk premium) and dividing by loss given default of 40%. 1Historical spread, price and yield reflect pre-credit crisis average from Jan. 31, 2000 - December 31, 2022, excluding 2008-2009 and March-Sept 2020, CS Leveraged Loan Index. 2Spread represented by Discount Margin (3-year life). 3Loss Given Default (LGD). 4Peak Default Rates and Actual LTM Defaults sourced from Morningstar LSTA US Leveraged Loan Index monthly default rates, the peak default month during 2009 was November. 5Fitch, Citibank and JPM respectively.
What are the risks of Private Credit?
Default risk is the leading risk in private credit markets. This is because private credit typically involves non-investment-grade borrowers. As such, thorough due diligence and credit expertise is important.
Liquidity is another key risk, because private credit securities are generally less liquid than publicly traded securities. Without a secondary market, illiquidity is a risk for investors who typically must hold the debt to maturity without having an off-ramp.
Private credit is complex and less transparent than public markets. Unlike other asset classes, it isn’t conducive to standardisation, which may be off-putting to some investors. A lack of standardisation brings with it other challenges around data comparability and due diligence – both of which are important in light of increased interest in ESG considerations.
Issues around standardisation and data have the additional effect of hindering creditors’ ability to monitor risk.
Investment risks
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The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
Alternative investment products may involve a high degree of risk, may engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, may not be required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual funds, often charge higher fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager.
Important information
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All data is provided as at the dates shown, sourced from Invesco unless otherwise stated.
This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication.
Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals, they are subject to change without notice and are not to be construed as investment advice.
