What if the private debt was more secure than the public debt?

2019-03-12

Ignorance or mistrust? The alternative income is a spearhead of the large American managers and Anglo-Saxon Family Offices.

While macroeconomic data continue to deteriorate, uncertainties remain significant (impacts of the US shutdown, French "yellow vests" or Brexit?), Central banks maintain highly leveraged balance sheets causing them to be, more than ever , "Market dependent", and the Sino-American agreement can only lead to a negative impact on trade, it is surprising to note that the consensus of economists, strategists and equity investors advocates for an astonishing optimism.

The "V" market recovery is a demonstration of this mind-set.... like if the volatility of Q4 2018 was already forgotten.

Increasing government debt is not in itself an insurmountable problem. At least, not if the economy is growing more than 3% and demography are increasing. Neither if public investments are concrete and allow an improvement of the productivity of infrastructures (in what way the wall in Mexico will improve the American economy?). Even less of an issue, if governments can implement important structural reforms.

However, in practice, none of this is visible. This debt's increase only serves to pay public expenses and buy back its own government bonds. In no cases have tax increases or budget reductions been used to repay debts ... as it has been in Switzerland.

Japan's debt is 260% of GDP. Japan continues to refinance at a ridiculously low yield and clearly has no intention of repaying it as long as it enjoys investor confidence.

The other central banks apply the same strategy; and investors "buy into it" without worrying about long-term effects or volatility that could impact the credit markets.

"Insanity is when always doing the same thing ends expecting a different outcome," said Albert Einstein

We are surprised that traditional portfolio managers continues to favour an allocation in government bonds, as a tool to reduce portfolio volatility, while more substantial investments in "private debt" or any other "alternative income" strategy could meet this need for decorrelation and lower risk of the portfolio.

This may be due to lack of internal resources or lack of knowledge (or even mistrust) of private issuers. And yet, the alternative debt is a spearhead of the big American managers and Anglo-Saxon Family Offices… Unless, it is because of the limited liquidity of this type of investments.

Yet, private debt offers a number of advantages:

  • Borrower's balance sheet analysis - usually an SME - is much easier and more accessible;
  • Having no access to the financial markets, SMEs indebtedness is lower than that of a government or a multinational with a credit rating;
  • The loan is secured, at a minimum, by an asset, sometimes also personal guarantees of the shareholders, with a loan-to-value (LTV) lower than the pledged assets;
  • In this type of SMEs, the majority shareholder is usually also the founder. He is very attached to his company, and thus to repay the loan, whatever the cost is;
  • The duration of this type of borrowing is shorter than the majority of listed bonds - ie from 12 to 36 months - or with a cash flow that can secure the payment of interest and amortization of the capital;
  • The interest rate is generally indexed to Libor, and thus the loan is immune from interest rate risk;
  • And the loan is not issued, if the project is not economically viable.

Not to mention, that this type of loan has a mark-to-market volatility much lower than a quoted High Yield bond. Investors in the European High Yield saw a majority of prices falling by more than 10% in 2018, and some reaching a - 50% (see table below):

Therefore, the reflection is to assess how much weight should be given to a private debt with pledged assets - but with a lack of liquidity - in relation to the liquidity of a listed bond - with the only guarantee being the borrower's good faith to repay ... or rather to refinance its debt on the market, in order to repay the obligation.

Only a justified return makes it possible to value the attractiveness of private debt. Some alternative managers (and in particular Swiss ones) have managed to specialize in this segment and are successfully investing in factoring, leasing transactions (car, aircraft, freight wagon), bridge loans, trade finance, mezzanine loans (real estate related) or royalties.

In 2018, these managers were able to achieve a return of 5% above a "global bond investment grade" index with zero or negative correlation.

It is therefore useful to devote a little thought on this asset class.

Mirko VISCO