Australia’s deep-pocketed asset owners continue to pile into the booming direct lending market as bond yields slide but are ignoring the lack of transparency within the US$812 billion asset class.

Capital has poured into direct lending ever since the banks scaled back on business lending in their struggle to deal with more onerous capital and liquidity rules.

Despite the appetite for direct lending, the lack of transparency is an obstacle, warned Thadeus McCrindle, chief investment officer, Sandhurst Trustees, ahead of Investment Magazine’s  Private Credit Forum in Melbourne.

“The lack of data makes it harder to assess these private credit strategies,” he said. “Historical returns are an important input into how you evaluate an asset class’s risk and reward potential and there is not enough data in this space for this analysis.”

McCrindle warned that private loan originators don’t have the lending history of the banks which means investments require a different type of analysis than taken on would be a high-yield bond manager.

“Where direct loans are arranged privately, there is a greater need to understand the risk of the actual loan and the reward as well as the likely default rate,” he added. “Instead of being able to trust a historical data and credit rating in your assessment of risk and reward, you have to think of more forward-looking data points as it is harder to see when loans start to sour.”

The investment chief said analysing non-bank loans is challenging when they are idiosyncratic loans in very niche businesses which provide no data. “My personal default position in that situation is caution whilst having a framework that includes the reality of prospective returns. It is helpful if you have internal experience in lending as you need to understand the fund managers credit underwriting controls and their bad loan work out processes. Some loans will default so you need an estimate of that upfront to compare different strategies and the yields they are generating.”

McCrindle said if asset owners are worried about a recession in the near term, then this asset class is not the right one for them to invest in. “Investing in this is a long-term commitment and you have to ride out the defaults that will surely rise when the credit cycle turns over, probably within a few years.”

The current build-up in corporate leverage, the decline in credit quality and lower underwriting standards are all consistent with late-cycle credit behaviour last seen in 2005 and 2006, according to the investment specialist.

In a bid to deploy cash, he thinks superannuation funds are investing in lower credit quality especially in high yield bonds and leveraged loans.

“I suspect that underwriting standards are falling particularly in public credit markets and that is traditionally a precursor to the end of a cycle,” he said.

He is not calling a recession in 2020 because calling the end of a long cycle early is not always a smart move. “However, we are getting later in the cycle; it has been a long cycle.”

The CIO said the prevalence of covenant-lite debts raises the question what would happen when a string of corporate defaults eventually hit.

“When you’re investing in portfolio credit in a private structure you’re investing for a while so you need to think about corporate defaults,” he added.

Higher risk loans are now considered to be an acceptable investment, according to the CIO. He cited the residential mortgage-backed securitisation (RMBS) market as a clear example the shift towards lower credit standards. “What is considered to be an acceptable loan pool is materially lightening and laxing and certainly has done over the last few years.”

McCrindle noted that not many years ago, interest-only loans and investor loans were viewed as risky and they made up just a small proportion of RMBS loan pools.

In 2018 and 2019, you started to see all interest-only and investor RMBS pools, he said. While these may still prove to be reasonable credit investments, it certainly raises questions about how stringent, or not, asset owners are about the credit quality of their loans and bonds, he added.

Elizabeth Fry is the editor of Investment Magazine's digital platform. Fry has been a financial journalist for more than 25 years and has written for a number of publications, including CFO, The Financial Times and The Australian Financial Review.
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