Vision Super will apply more focus to the capital structure of its private debt activity as underwhelming bond returns and an unsettled market increase the importance of quality in the defensive assets held within portfolios, according to the fund’s market strategist Stephen Nash.

The pandemic’s effect on global fixed income rates – which are at all-time lows – has made defensive asset classes “a little bit difficult”, Nash says in an interview with Investment Magazine.

As a result, he explains, investment managers are going to think less about interest rate risk, and more about the capital structure, as a way of creating the new defensive portfolio. This will involve, among other things, concentrating on the top end of the capital structure in private debt investments.

“So that means instead of providing funding to equity, people are going to focus on the more senior secured lending side of the capital structure so you can generate decent spread and still have quite a secure situation where, in a default, you have specific rights that can be exercised,” Nash says.

Vision Super’s preference for private debt is no secret – in February Nash told Investment Magazine’s Private Credit Forum in Melbourne that the fund was considering the use of a private credit manager, which was “appropriate” at this point in the cycle given an expected turnaround in the long equities run.

“We are looking at debt more than we had for quite a while, so that is quite a bit of change for us,” Nash told delegates. “Other funds are doing the same. We have had a great decade for equities, but we think the next decade won’t be as good, and that will naturally mean a more prominent role for debt relative to equity.”

While this theme remains, the narrative has developed as persistently low ten-year bond rates and volatility have heightened the need for debt security and downside protection. Private debt was not seen as that important when 10-year government bonds yielded 5 per cent, Nash says, but now that 10-year government debt yields less than 1 per cent, the need to look at private debt has increased dramatically.

Any move to private credit, however, needs to be made judiciously.

For Nash, that means directing managers to be “conservative in terms of the credits they lend” and avoiding “exposed and imprudent” companies.

“We’re trying to avoid companies that are evolving quickly with little borrowing experience and are quite leveraged,” he says, adding that the fund is looking for solid, well established companies with a “consistent program” of debt financing. “We’re generally not interested in providing debt finance to venture capital type companies, although that might make sense in special situations.”

The fund hopes never to need the security, he says, “but it’s there as a backstop” and the pledging of security takes the edge off the risk, which investment managers typically take on with unsecured lending.

“It’s important in these situations to have that security, [for it] to be there when you need to have a defaulted loan,” he says.

He points to the robust Australian regulatory system as another reason the fund is increasingly turning to secured private debt. “Private debt in this country is particularly attractive, mainly because we do have a very strict legal regime, which assists the lender” he says, noting that recoveries in Australia are “typically higher than in most other jurisdictions”.

Overall, Australian credits have performed “quite well”, he adds, with generally lower default and generally higher recovery rates. While these results may create some froth in the private debt space, Nash says, this necessitates the need for increasing levels of due diligence and analysis of all private debt.

Accordingly, Nash says that “more competition in the private debt market will improve private lending standards, but only over time”.

“I just think the opportunity set has shifted substantially to support the growth of private credit in the last few years,” Nash continues. “The private debt space is going to get a lot bigger than we can even estimate at the moment. It’s an exciting time in private debt right now.”

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