Cedric Rozier, head of private credit and housing associations at Phoenix, highlights where to find value and tackling the scarcity of assets
How is the IG private credit market looking right now?
First off, I'd say that the economy has been surprisingly resilient, even if the macroeconomic background still has some uncertainty hanging around it. We do see downside risks from a few potential places, such as the lagging effect of high interest rates or a negative surprise on the moderation of inflation. There's also an acute geopolitical uncertainty this year which can impact supply chains and the overall appetite for risk. On the other side of the coin, whether you are looking at Europe, the US, or the UK, spreads are quite compressed. It's about one standard deviation inside long term averages in the USD and the GBP markets for example, with the same holding true between BBB and single-A credits. What does that mean? It means that on average we see more value in high quality credits with more resilient business models and conservative leverage.
And this is against a backdrop in which this sector has been seeing something of a boom?
The private credit market has boomed since the Great Financial Crisis. You've had banks in the US and Europe reducing their lending volumes given increased pressure from regulators. There is also, for some institutions, some degree of tension within their commercial real-estate exposures. So we have the banks that are continuing to draw back from lending and, in parallel, there is a lot of demand from institutional investors. What we've been seeing so far is an increasing number of players, such as alternative managers, coming into the market. They're now looking for private credit in the investment grade space as well.
What are the challenges and pressures that we're currently seeing in this space?
One of the challenges is a scarcity of long-dated issuance to mirror long dated liabilities. In the context of peak rates that are expected to decrease, some borrowers have been keen to avoid locking in higher debt costs despite the tightness of spreads. Another challenge, in the context of high investor demand, is looser terms being accepted. We are very mindful of this, and we will pass on deals where we believe the structure is not protective enough.
What can the insurance industry do about the scarcity of long dated assets?
One avenue has been developing access to a broader, wider range of assets. For example, credit-tenant leases (CTL). Current market dynamics can necessitate long-dated funding to make a real estate project financially viable. A CTL therefore creates a robust structured funding solution secured on real estate to match long dated liabilities, with credit exposure to high quality counterparties. These assets are more structured and take more time from a legal perspective, but they can provide a nice cash flow schedule that you can put in front of long-dated liabilities. Inflation linkage is also a positive for a balance sheet such as ours.
What are the defining characteristics of the private credit market?
There's a lot of demand and a sizeable market, and we are now seeing larger and larger companies that can bypass bank or public bond financing and come instead directly to a market that provides a lot of flexibility and certainty of execution. They also don't need an external rating because investors like ourselves can do their own credit assessment. At Phoenix, we have a whole team that's dedicated to credit research and ratings. On the investment side of the coin, the whole reason we invest is that we can access the same quality of companies with a pickup for the illiquidity feature. We are long term buy and hold investors, in exchange, we get that attractive pickup as well as downside protection through covenants.
What are you looking for?
On the Shareholder side of the business, the things we're looking for are resilient investment-grade quality assets that are matching adjustment eligible. We also have a natural appetite for duration. We are sector agnostic, but we are naturally geared towards more defensive sectors. We're here for the long-term. When we make an investment, we spend a lot of time doing due diligence, stress testing the credit, and structuring the loan to make sure that we will be comfortable with our holding through the business cycle. We don't want to have an investment in a company where a downcycle causes a material downgrade risk. That's absolutely key for us when we assess a new investment.
Why are insurers increasingly turning to ABSs, and what are these early adopters hoping to find?
ABSs have traditionally been underexplored as an investment opportunity for insurers. Until recently, a lot of ABS issuers had no good reason to engage in the structural requirements to make this asset class into a viable option. Two key things have happened to create the conditions to make it more of an area of focus. The first thing is the retrenchment of traditional providers of finance, that shrinking in the bank sector that I talked about before. Because of this, there has been more of a willingness amongst issuers to flex the terms and to bring in insurance capital. The second thing is the Solvency II reform. For the wider market, this area is a candidate for "highly predictable" portfolios. In terms of what investors are looking for, the focus is on finding transactions with the structural features which would permit inclusion within an annuity portfolio, e.g. prepayment protection. If you add this to an attractive pricing premium over other investable assets, this is an interesting area of development for us.
How do you see the different models for the business? The agented vs. the direct?
They've both got their merits, and I'd say that agents play a crucial role in new opportunities. They can notably identify and advise new entrants to the market, so they're key to us at Phoenix. Now it is fair to say that if you have a long-term relationship with a company in your portfolio, you know the credit, the management in charge, and have the documentation in place, a direct deal makes sense. But I do see the real benefits to both models.
You're based in the UK, but what US business do you do?
We invest in the UK, the US, and also in Europe. We can also look at a few other currencies. In fact, we've been quite keen to diversify away from purely sterling credit, so we've been deploying a lot into the European and US markets. This allows us to find better risk-adjusted returns overall because the borrower pool is much wider. Now our liabilities are in sterling, so whatever we do is always swapped back into that. The cross-currency dynamics then come into play for us.
How does the currency swap factor into your thinking?
When we originate the deal, we look at the local currency to make sure we are getting the illiquidity pickup. If we are buying in Europe, we want to make sure that we can't find the same return from liquid European names of comparable credit quality. we also want to make sure that post swap we are crystallising a good pick up versus the GBP market which is the natural currency of our balance sheet. If the cross currency is not in our favour at a certain point in time or for certain durations, then we're just going to look at deploying elsewhere.
Pete Carvill
