Aviva Investors: The impact of COVID-19 on private debt

The speed and scale of the COVID-19 pandemic globally has caught investors off guard. All asset classes have been hit by the unprecedented combination of a global supply and a demand shock. The violent moves in share prices caused US stock exchanges to halt trading several times in March, with even safe havens such as US Treasuries and gold being impacted.

 

Private debt is no different, though the extent of the damage remains unclear due to the built-in price discovery lag. While infrequent valuations may help shield investments from daily swings, as information starts to come through fears around contagion from public markets could materialise. With expectations that global growth will be negative at least in the first half of the year, notably a sharp contraction in Europe, pricing pressure is likely and deal flow should slow in the short term.

 

In contrast to the 2007-2009 financial crisis – perhaps because of what they learned from it – central banks have responded quickly to COVID-19, signalling they will do ‘whatever it takes’ to keep markets functioning. Additionally, governments around the world have been quick to announce unprecedented  and massive programmes to deal with the economic fallout, with measures including loans, tax deferrals, bailouts and other support for impacted businesses. In the US, for example, a $2 trillion (£1.63 trillion) stimulus package is the largest in history. Earlier in March, Germany’s government announced plans for set up a €500 billion (£450 billion) bailout fund for impacted businesses and the UK government unveiled a £350 billion lifeline to help the economy through the health crisis. 

Ascertaining the short-term outlook for private debt markets is a complex task; on the one hand, prolonged easy monetary conditions potentially could encourage more deal flow, but this will likely be offset by challenging financing conditions as lenders become more risk averse.

Here, we examine the implications of COVID-19 on real estate finance, infrastructure debt, private corporate debt and structured finance.

As in public markets, the impact will not be shared equally. Retail, hotel, leisure and other non-discretionary sectors will initially bear the brunt of travel restrictions, forced closures, social distancing policies and other measures to contain the spread of COVID-19. All things being equal, businesses in service sectors will not be able to recoup revenues lost from the disruption.

 

Other areas that could be vulnerable include the office sector, particularly those catering to tourism, leisure and manufacturing. In some areas, structural shifts were already apparent as companies look to reduce office space and the COVID-19 outbreak may accelerate those trends. In the flexible office workspace sector, growth may also prove to be muted due to falling demand, at least in the short term. While COVID-19 has created a surge in certain types of e-commerce orders, which in theory should support logistics assets, this has been offset by a severe disruption to global supply chains.

It is too early to know whether the pandemic will leave a more permanent mark on real estate financing, but some signs of stress have already appeared. Anecdotal evidence suggests deal activity has slowed dramatically; rental income will likely be lower than expected.

 

However, large scale government monetary and fiscal support could help reduce some of the short-term financial pressure to enable businesses to survive. In the UK, for example, the government has temporarily banned proceedings to evict tenants due to the COVID-19 disruption, essentially making rental payment optional to help alleviate cash flow problems.

Lenders with stronger risk management processes should prove more resilient. For example, transactions with conservative assumptions on the outstanding loan amount relative to the property value and expected operating income against debt service obligations would allow investors a wider cushion against short-term business disruption. Exposure to senior debt collateralised by the underlying property provides additional protection. The exceptional circumstances of COVID-19, however, will require lenders to be more flexible, working together with borrowers as partners for the long term.

Historically, infrastructure debt has performed well in times of market stress because of its more stable, long-term characteristics. Its key role in helping economies recover may provide a strong incentive for government fiscal support, although further clarity is needed on where state support will be directed.

 

An increase in infrastructure investment by governments had already been targeted before COVID-19. McKinsey Global Institute estimated about $3.7 trillion in annual infrastructure investments would be required through 2035. In the UK, the National Infrastructure Assessment (NIA) pointed to several infrastructure priorities: nationwide broadband by 2033; renewable energy to form 50 per cent of the national energy capacity by 2030; £43 billion of long-term transport funding for regional cities; and flood resilience for all communities by 2050.

With economic activity disrupted and markets dislocated, though, investors are first reconsidering the risk profile of their existing portfolios. The combination of COVID-19 and increased oil supply from Saudi Arabia, for example, may jeopardise expected income from infrastructure projects that are dependent on energy prices. In contrast, social infrastructure projects with government-backed cash flows may be more resilient, especially when compared with economic infrastructure assets such as airports, ports and motorways.

 

The illiquidity premium typically associated with infrastructure debt is eroding due to the COVID-19 crisis. Public market spreads are widening much faster than their private market equivalents, which tend to lag in terms of pricing. In addition to completed projects, private debt that support projects currently under construction also face dislocation. With supply chain disruptions and labour shortages, these projects may not produce the level of income expected or on schedule.

The strain in European leveraged loans is especially acute in discretionary sectors such as leisure, travel, auto and retail. The dislocation in the market is evidenced by the 380 basis points widening of the iTraxx Crossover Index in early March. The rise in the index, which measures the cost of protection against the risk of default for European companies with sub-investment grade ratings, was at its steepest level since 2016.

 

Even after central banks lowered borrowing costs and governments throughout Europe pledged their support to help businesses, the iTraxx Crossover Index remained elevated – an indication that in this crisis, investors will not be reassured about the potential effectiveness of large-scale interventions until the health risks are managed.

Careful analysis of borrowers’ liquidity positions will be crucial; balanced by the need for lenders to be flexible in helping businesses in their recovery, for example by granting payment holidays. Investors will clearly need to reassess their risk tolerance for private corporate debt, with an increasing emphasis on covenant protection, leverage and refinancing risk. More defensive portfolios with less exposure to impacted sectors or to companies with highly leveraged balance sheets may be better positioned to withstand the short-term pressure. Higher diversification by geography, sector and deal size should also help.

 

New deals appear to be on hold, however, with price discovery increasingly difficult. In the current market, loan prices can fall even for well-run companies. For patient investors, the environment may eventually offer opportunities at higher yields and more favourable risk-return characteristics.

As long as the economic stress from COVID-19 remains temporary, and consumers and businesses can resume economic activity fairly quickly, structured finance markets should continue functioning. In the short term, though, new business volumes may be reduced with most borrowers and lenders taking a ‘wait and see’ approach to see where spreads settle.

 

The transaction volume in the secondary market, however, is expected to increase with further repricing, although the full extent of COVID-19’s impact on private debt spreads has yet to become apparent. Securities issued in certain sectors – again such as retail, entertainment, travel and hotels – will be more vulnerable. 

A major concern for investors is the extent to which recent spread widening is attributable to funding pressures versus pure credit risk. Lower interest rates could temper these concerns, though continuing quantitative easing is generally negative for investors in structured finance because of the artificial liquidity injected in the market, reducing the need for deleveraging by banks.

Meanwhile, sovereign credit risk is rising due to the unprecedented financial support packages needed, potentially impacting guaranteed transactions, including aircraft asset-backed securities. In general, however, debt backed by fiscally disciplined governments or with sufficient credit enhancements and liquidity provisions should be more resilient.

The full impact on private debt portfolios will depend on how fast the virus can be contained and the effectiveness of measures by governments and central banks to mitigate the economic damage.

 

Private debt investors will need to monitor the situation closely for signs of a more severe or sustained crisis. While each crisis has its own characteristics, investors will inevitably look for parallels with the global financial crisis, when certain pockets of the private debt market such as infrastructure showed more stability relative to their public market equivalents.¹

As and when an end to the crisis is in sight, and investors are once again scanning the market for opportunity, rigorous credit selection will be even more critical. In such an uncertain environment, the origination of investments will need to be accompanied by robust credit processes, in-depth sector expertise and careful structuring – all the while striking a balance between risk and reward.

Reference
1. ‘Default and recovery rates for project finance bank loans, 1983-2016’, Moody’s Investors Service, 5 March 2018

 

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