Growing shortage of higher-quality credit is pushing institutional investors to take on greater risk
Anaemic return prospects in traditional fixed income have pushed Canadian pension funds and insurers into the rarefied world of private credit. But as many businesses get crushed under the weight of the COVID-19 crisis, the pool of high-quality opportunities for institutional investors has gotten decidedly smaller.
In a recent report by Reuters, institutions such as CDPQ and Sun Life Financial have been raising their allocations to private debt, which according to Deloitte offer 10% yield compared to roughly 5% for Canadian high-yield corporate bonds.
However, private-debt prospects for institutional investors are growing slimmer. Repeated lockdowns induced by the pandemic have slammed businesses, with smaller privately held companies suffering more than their larger publicly traded rivals. The resulting financial vulnerability has crimped their ability to raise debt capital.
“Ironically, for the companies that need the help, the banks don’t have the appetite to lend to them, but neither do many private credit funds,” Andrew Luetchford, capital advisory partner at Deloitte Canada, told the news outlet.
Faced with a shrinking pool of opportunities, institutions are forced to either accept lower returns or invest in lower-rated firms. To mitigate the risks, Ninepoint Partners Managing Director Ramesh Kashyap said large investors are formulating stricter covenants and limiting the amounts they lend.
“For firms that are solely focused on investment grade credit... the universe is smaller than it was a year ago,” said Fitch Ratings Director Dafina Dunmore. She confirmed that there’s an ongoing downward ratings migration among investors, projecting that it will persist until 2021.
Adopting a “press on regardless” attitude, some pension funds are going ahead with plans to raise their exposure to private debt. Jérôme Marquis, head of Corporate Credit at CDPQ, said the fund is anticipated to hit $50 billion of private-debt investment in the next four years, following a doubling of that allocation to $35 billion since 2016. He said that while others retreated from the private-credit space during the coronavirus crisis, CDPQ continued to invest, which bolstered its ability to deploy capital.
Brad Meiers, debt capital markets head at HSBC Securities Canada, told Reuters that he expects debt issuance to resume after a recent lull during the run-up to the U.S. presidential election, which coincided with broad fears of a second wave of COVID infections. But he doesn’t expect the markets to regain lost ground.
“[W]e will not make up the deficit of issuance supply that we normally see this time of the year,” Meiers said.
According to Dunmore, Canadian institutions whose footprint goes beyond Canada may consider investing internationally. SLC Management, Sun Life’s alternative investment arm, recently bought a majority stake in U.S.-focused credit manager Crescent Capital to raised its private-debt exposure; it said the U.S. accounts for around 60% of global private-debt issuances, which it said amount to US$100 billion annually.
Not everyone is willing to settle, however. Sticking to its investment-grade credit convictions, Manulife Financial said it is allocating less to private debt this year as borrower demand softens.
“We do not compensate by going down in quality,” said Manulife Chief Investment Officer Scott Hartz, who said the company is content with public corporate debt returns as credit spreads widen.