Why the US may have reached a peak

Concerns about loan covenant standards are growing

Competition in the market has forced private lenders to make concessions to secure higher yields for their investors. However, with lots of capital chasing every opportunity, pricing has started to tighten and leverage levels are creeping up. If institutional investors are chasing a higher level of yield than the market is prepared to offer, private debt funds will have to find another way to compete if they are to secure those higher yields from the businesses they lend to.

Fierce levels of competition have allowed chief financial officers to demand less restrictive loan terms in return for paying higher levels of interest. Supporters of more relaxed underwriting point to the fact that the number of loan defaults remains low, despite the ongoing concerns about lending standards. However, this may not tell the full story. Defaults may be at an all-time low because there are no covenants upon which to default.

Loan leverage is rising

According to figures from Schroders, the US leveraged loan market had ballooned to $1.1 trillion by the end of 2018, nearly twice what it had been just seven years previously. This could greatly inflate the losses investors will be expected to shoulder if market conditions deteriorate significantly. “The debt cushion beneath the average loan has gotten smaller throughout this cycle,” Michelle Russell-Dowe, head of securitised debt in Schroders’ US fixed-income team, told us. “This means loan losses, in the event of default, are likely to be higher – especially given the increasing prevalence of loan-only deals – relative to past experience.”

Nervousness about the economy is building

Monetary policy has been a key focus for private debt because of the inverted yield curve: the yield on 10-year Treasury bonds has dipped below that of shorter-term bills. The Federal Reserve maintained it would not respond to “short-term” swings in the markets, but eventually cut the rate by 0.25 percent on 31 July. This, coupled with ongoing uncertainty about the trade war with China, has caused some investors to review their allocation to US private debt.

ESG investing is creeping up the agenda

Investors are beginning to expect asset managers to factor environmental, social and governance-based criteria into the terms of any loans they make.

Once the preserve of the global equity markets, the arrival of ESG metrics into US private credit can partly be explained by UN-backed organisation the Principles for Responsible Investing introducing new guidance on sustainable investment for private debt funds.

“Responsibility for responsible investing extends beyond the equity stack and captures lenders too,” says Matthew Craig-Greene, managing director of data and analytics at investment consultancy MJ Hudson.

In February, the PRI launched a tailored ESG due diligence questionnaire for private debt funds, covering policy and governance; evaluation and pre-investment; and post-deal monitoring.

Write to the author at andy.t@peimedia.com.

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