Properly managed, private debt offers attractive yield in a rising rate environment

It's easy to jump to the conclusion that today's rising rates make private debt securities riskier investments. The relationship between the two isn't as handcuffed as you might think. 

Credit spreads on the yields offered by government securities and private debt securities of equivalent durations are a good measure of perceived risk in the market. This is what's referred to as the risk premium. Simply put, higher yields compensate you for taking on higher levels of risk. 

"If we look at what is likely to occur if interest rates were to rise and inflation risks were to rise, but we're talking about a 'soft landing', then credit spreads don't need to move materially wider than where they are now," says Andrew Papageorgiou, Head of Bank Capital and Corporate Capital at REALM Investment House. 

Against that backdrop, private debt investments such as wholesale lending make a lot of sense - so long as the risk premium you're paying for is kept to systematic risks. And that's what Andrew will take us through in the Expert Insights. 

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Realm Short Term Income Fund

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Edited transcript

What can history tell us about today's credit markets?

Credit markets are interesting when you look back through time at what happens to credit spreads as rates rise. Again, once again, the numbers don't speak to there being a positive correlation between bonds and credit spreads. Okay. Credit spreads will start to reflect increased risk when they feel that recessionary risks start to rise and economic stability is at risk. And then you've got to also remember, there's only so much businesses can afford to pay at the end of the day. So rates have certainly been higher. Okay. 

All-in rates have certainly been higher than they are today, but if you look at the composition of those rates when you go back through time, a bigger proportion of those relate to the interest rate component, so the risk free rate and a smaller component actually relates to the credit risk associated with the lend, okay, or with the securities in question.

So if we look at what is likely to occur as we move forward if interest rates were to rise and inflation risks would arise, but we are essentially talking about in this instance soft landing, well, credit spreads don't necessarily need to move materially wider than where they are right now. I think certainly the widening that we saw late last year and early this year was warranted. It was warranted because credit spreads had gotten so tight through 2021 because there was so much liquidity and rates were as low as they were. So we had the US BBB 10 year credit spreads, for example, were at 100 over US treasuries. They currently find themselves at 161 over. So they've sold off a full 60 basis points. In total return terms, that's a negative price movement of around 5% to 6%.

Here in Australia, Australian BBB corporate credit spreads at a 10 year attachment point are now sitting at 2% over the risk free rate where if we go back about six or seven months ago, again, they're in the low 100 over type neighbourhood. So things have already widened a fairway. For them to widen from here, you need those recessionary risks to rise, you need the prospect of a hard landing to increase. 

And in terms of what echos, what rhymes, what are the scenarios you'd be worried about in that instance, you look at situations where controlling interest rates or interest rates have gotten out of control and have had a negative feedback loop into the real economy.

So I think people have a certain vintage of mind, for example, that were sort of around and saw their parents struggling with interest rates in the mid to high 10s would speak to that being almost the type of disastrous outcome there where you lose the leash and inflation runs down the street and then you're chasing your tail and increasing interest rates materially to try to soften things. And in that type of scenario, yep, certainly. That situation would be adverse for credit markets generally, and certainly here in Australia, but again, you've got to be really careful when you're dealing with markets generally that you are not becoming fixated on a single scenario.

So when we are sitting here today, think about it probabilistically. There's all these different stuff that could happen. There are numerous potential realities, that is maybe one of them. You have to actually assign a realistic probability of it occurring, okay. 

And by the same token, you don't want to be fixated by the tail, but you also don't want to be modally fixated either, which means you don't want to be just absolutely focused on what you think is the most likely outcome. Because that doesn't reflect the potential risks enough.

So given the changing circumstances and we are certainly dealing in this post GFC world, we're certainly dealing with something very different and that we are dealing with extremely large levels of debt all over the world. If you look at households or you look at governments in the case of the US and you're talking about rising inflation or rising rate environment, you're dealing with an environment that's increasingly uncertain, okay. So our perspective would be that what we are looking at is we're looking at a distribution of outcomes that's quite fat tailed. That should mean that your level of conviction around your positioning should be pretty low right now, okay.

So once again, learning from history, what we want to be focused on is taking into account that outcomes could be varied, and our level of certainty around forecasting and predictions right now should be by all rights low. And that just requires you to play in a pocket, to be very, very careful in terms of how you move forward and to understand the risks that are likely or have the ability to develop as we move forward.

Why should investors move upstream into wholesale lending?

Wholesale lending is an interesting part of the market that we've sort of gotten dragged into over the last six or seven years over here within realm. We were always very good on the RMBS and ABS side. My co-founder Robert Camilleri at a long and storied career sort of dealing within RMBS and ABS markets. And we naturally got drawn into going upstream as far as the RMBS and ABS manufacturing process is concerned. So when you think about wholesale banking, wholesale banking is the process by which these RMB securities are created, okay. So a wholesale banking facility is essentially a line of credit that's given to one of these larger lenders. They use these facilities to write loans, and once they have a marketable parcel of securities, it then gets turned into a RMBS that is purchased by the market.

Now, why do you want to get involved upstream? What is the value of being involved within the constructional manufacturing process of these RMBS instruments? Well, the reason is that you're compensated for it, okay, because those securities and facilities are liquid. You are paid a market rate that is above what you would generally receive by holding the public RMBS security. You are generally benefiting from additional covenants on the security. So those facilities, because they are tripartite agreements between banks, the issue of themselves and the mezzanine lender, which is generally the role we play. There are additional protections around the performance of the pool and the composition of the pool and so forth.

So the security is pretty good, the level of compensation is excellent. But ultimately, when you're talking about wholesale banking and the warehouse funding, part of the process is it relates to mortgage lending and asset backed lending, what you're getting is you're getting broad systematic risk. 

So the whole process of loan pools or RMBS or private RMBS is all around achieving a transformation of sorts where the risk goes from being highly idiosyncratic, which means dealing with individual risks, okay, and you transform it into a systematic risk, okay, which is essentially you're left with the broad risk of the financial system. That's what you want to be achieving.

So if you think about it, if you compare it with other securities or instruments, if you think about a bank hybrid for arguments sake, bank hybrid is in some ways an insurance policy, you sell the bank. Okay. It is capital that in the event that really, really bad stuff happens, that those securities will be turned into equity, and that equity will probably suffer large losses. Okay. But what makes a bank hybrid palatable is ultimately you have the protection of all the bank's earnings of the broad scope of the bank's balance sheet.

With mezzanine lending within wholesale banking facilities or within the broader warehouse space you should, when done right, be exposed to these same systematic factors. You should be exposed to very, very large broad diversified loan pools that reflect the broader risk of the economic system. 

That's to be distinguished from one single mortgage, for example. If you think about Mr. Jones and Mrs. Jones, they have the ability to default for any one of a number of reasons. They might become unemployed, in which case, the unemployment rate is 100%. They may be uninsured or underinsured. They may suffer ill health. They may have built in a flood plain and be underinsured for arguments sake. There's any one of a number of reasons why one individual might default, okay.

The math is simple enough. You put enough of these people in the one bucket and you diversify that risk. And those individual idiosyncratic risks, they wash away. And what you are left with is broad market risk, okay. So the reason we like this form of private lending especially when you compare it to other forms of private lending, for example, lending private debt to companies or lending private debt to a single property development for arguments sake, we feel this type of risk is superior, right? And we think it's superior because again, the idiosyncratics get washed away, all right.

So let's contrast that with a single property development where you might be exposed to the failure of a construction company, where you're exposed to liquid data damages, where you're exposed to overrun, where you're exposed to insurance risks. Okay. And when all said and done, you're exposed to that one site. Let's compare that with lending money in the leveraged loan market to a low rated issuer that would be on any given day rated at single B or B plus for arguments sake which is low sub-investment grade. Now what they try to do within that market, they try to use covenants and use security to reduce the relative risk of the underlying lend.

And very often they're quite successful in doing so, but it doesn't reduce the fact that at the end of the day, you are still exposed to that one company, that one industry and the failure rate associated with that management group. 

By contrast, wholesale banking or warehouse funding, as it's sometimes called, you have exposure to the Australian economy, you're going to be exposed to thousands of mortgages or credit card loans or auto loans. Those risks are going to be diversified geographically, they're going to be diversified by product, they're going to be diversified by underlying risk. 

And the credit rating agencies, even though I think a lot of people, when you think about credit rating agencies and RMBS, everyone's mind goes directly to the big short, right. But the reality is that post that period, they started to do their job properly. Okay. So if anything, you could argue that the ratings-based criteria is quite often quite conservative on a relative basis and the stress tests are probably more punitive than what we actually end up experiencing even in high stress events like COVID, for example.

So on that basis, we just tend to feel that it is a really, really good source of liquidity premium, because again, you're getting a pickup over like-rated or like risk securities within public markets and complexity premium. Because it is hard to get a seat at the table, there's legal work that goes around getting these agreements up, there's the need to be able to run the rating-based criteria internally yourself, there is a lot of work to be able to assess the risk properly, and you need to be paid additionally for that. So in terms of the compensation we're looking for in those deals. 

We're looking for premium for iliquidity because their securities aren't tradeable versus other types of securities, and we're looking for a premium for how complicated the instruments are, complexity. 

Because essentially, they are more complicated, they're harder to explain. As a consequence, the idea is harder to sell to the end investor, and essentially, the investor should be compensated for those risks. So on that basis, that's why we like that wholesale ending space.

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