A market where banks and funds co-operate
Those who view the world in stark “bank versus private debt” terms may not have come across the niche world of significant risk transfer. This is the subject of a market commentary from AXA IM Alts and makes clear how what is perceived to be a competitive relationship can also be a highly complementary one.

In essence, SRT involves an investor selling protection against a selected portion of a bank’s loan book defaulting. This enables the bank to improve its capital adequacy ratio while the investor obtains stable cashflows through the premium paid by the bank for protection against loss.

According to AXA IM Alts, the SRT market has been growing rapidly in recent years and has doubled in size since 2016. The market has been assisted by recent disruptions to the banking sector and the continuing need for banks to raise regulatory capital to improve their balance sheets and profitability.

The cost of capital, already under pressure from rising interest rates, is likely to rise higher following certain bonds (known as Additional Tier 1) that the banks used as “shock absorbers” in the face of possible collapse failing to perform that function in the case of Credit Suisse.

AXA IM Alts thinks that increased scrutiny of the AT1 market could be useful to the SRT market. While both provide capital relief to banks, SRT transactions do not form part of the bank’s liabilities. SRT offers “appealing premiums and an important source of diversification” according to AXA IM Alts.

Marks highlights CRE concerns
Assessing the significance of the SVB failure in his latest memo, Oaktree Capital Management’s Howard Marks sees little danger of a re-run of the global financial crisis. Referring to it as a “special case”, he says SVB was “particularly vulnerable to a bank run if adverse circumstances developed – and they did… I don’t think SVB’s failure suggests problems are widespread in the US banking system.”

However, that doesn’t mean to say banks in general get off the hook. Marks points to certain things SVB had in common with other banks, including asset/liability mismatches (“no bank can have enough liquidity to meet its needs if enough depositors ask for their money all at once”) and high leverage.

He also sees stresses building in the commercial real estate sector, where banks are estimated to hold about 40 percent of the $4.5 trillion of outstanding CRE mortgages (around $1.8 trillion). Losses on CRE mortgages could leave banks undercapitalised, in Marks’ view.

“No one knows whether banks will suffer losses on their commercial real estate loans, or what the magnitude will be,” says Marks. “But we’re very likely to see mortgage defaults in the headlines and, at a minimum, this may spook lenders, throw sand into the gears of financing and refinancing processes, and further contribute to a sense of heightened risk.”

Cautious tone in S&P report
“Overall, private credit is likely feeling a similar pinch to the public markets,” says a report from S&P Global Ratings that throws a spotlight on several areas of concern.

The report finds that: sponsor-owned companies are at the lower end of the rating scale, with S&P’s methodology “assuming that financial risks for a sponsor-owned company are commensurate with those of highly leveraged companies”. Around 75 percent of borrowers rated B and below are fully or partially private equity owned.

Within the collateralised loan obligation universe, 75 percent of companies making up CLOs have a B- rating and 10 percent are CCC. By contrast, only 36 percent of rated corporate issuers in North America are rated B- or lower.

Software services and healthcare businesses – which have been highly popular targets for private equity and private debt in recent years – are identified as “most vulnerable” to current economic conditions. Software has the second-highest leverage at 7.8x and the second-lowest cash interest coverage at 1.4x.

Business development companies are mostly rated BBB-. Exposure of BDCs  to payment-in-kind loans “represents a risk to these asset managers” with payment-in-kind increasing, partly as a result of the tendency to “amend and extend” loans.

Essentials