The resilience of Private Debt in rising rate environments

Private Debt Boutique

KATCHING OPPORTUNITIES

We focus on senior secured direct lending strategies with short durations that offer stable and attractive returns, protection and liquidity.

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Investors continue to face a challenging macroeconomic environment and equities are likely to stay volatile. Headline inflation numbers might have peaked, and future interest rate hikes are broadly priced in, which is a big relief. However, it remains unclear if major economies just entered a shallow recession, or whether it is the beginning of a deeper contraction.

On the fixed income side, much of the pain is probably behind us. The US investment grade corporate bond index has fallen close to 15% so far this year but future sell-offs are likely to be limited. However, as a result of the recent interest rate increases, there is not much value to find. The current high inflation numbers might still be stickier as many economists believe, driven by the ongoing energy crisis, supply chain bottlenecks and higher inflation expectations. It is important to remember that inflation expectations are the most important inflation driver, and expectation might stay higher, as central banks have lost at least some credibility after presumably reacting too late to the inflation spikes.

We expect US core inflation to stay above 3% by mid-2023, and as long as inflation is above 3%, the correlation between equities and bonds remains positive, which means they rise and fall in tandem.

Traditional portfolios remain volatile unless investors diversify into alternative asset classes. Commodities and some hedge fund strategies, such as managed futures, might provide an interesting hedge against further inflationary pressures and tail risks. Even so, these asset classes are highly volatile and therefore negatively affect the risk budget of investors.

Private debt offers an attractive alternative for conservative investors. Even though they are related to fixed income assets, private debt strategies have proven to be resilient in rising rate environments. There are different explanations for this resilience.

First and foremost, most private debt strategies use floating rate loans, or fixed rate loans with relatively short durations, and relatively high interest rates. Therefore, the technical duration is very low, which means there is a very low sensitivity to rising benchmark interest rates. Intuitively, it is easy to understand that a private loan, with an interest rate of 12% and a duration of 1 year, as an example, is much less sensitive to the fact that a central bank increases the target rate from 1% to 2%, versus a 10-year corporate bond that has a coupon of 3%. The share of the risk-free component is much higher in a longer-duration, high-grade corporate bond.

Secondly, private loans are typically bilateral agreements. In many areas, especially the overlooked niches, private debt managers have relatively strong bargaining power when negotiating the credit terms, because the potential borrowers might struggle to find alternative lenders. Thus, many strategies are senior secured, with strong guarantees and covenants. This makes the loans less volatile and less sensitive to economic variables. One of the niches that is particularly interesting is real estate lending, for example bridge loans that are backed by a first-lien charge on a property, and thus collateral provides inflation protection. Of course, it is important to focus on areas of the real estate market with positive fundamentals, e.g. thematic opportunities, areas with floating rents (such as hotels, student housing, etc.) and other areas with favorable supply/demand characteristics.

Finally, private assets generally experience less volatility, because they are not traded in public markets and are therefore less affected by investors behaviors and herd instincts. Valuations are based on fundamentals of the borrowers, as well as the quality of guarantees and collaterals.

Given the current uncertainties, investors are well advised to focus on managers and strategies that focus on downside protection. This is exactly what Katch Investment Group characterizes. Every investment decision is always based on protecting the capital across all the different niche strategies. The track record has been strong and resilient during the pandemic, and, more importantly, during the inflationary shock and interest rate hike phase in H1 2022.

In summary the main reasons for the resilience are:

  • Short Duration. All our investment strategies have a short duration that ranges from 45 days to maximum 2 years. We do not rely on secondary markets for our liquidity purposes.
  • No leverage. Katch does not use any leverage in any of its funds which not only means lower volatility in general, but also reduces the risk of higher interest costs and minimizes the liquidity risk.
  • Currency hedging. All currency exposures on a share class level and investment level are full hedged and constantly adjusted via forwards, NDFs and futures.
  • Real Estate Collaterals. Our lending funds focus on senior-secured loans with strong collaterals, typically real estate collaterals with a focus on thematic projects with strong value creation.
  • ESG Considerations. Katch is funding several sustainable projects with an ESG angle, such as electric batteries, alternative energy, and sustainable housing in Europe. These projects should gain further support as Europe aims to reduce the dependency on fossil fuels.
  • No exposure to Eastern Europe and Russia. We have zero exposure to Russia and Eastern Europe. Additionally, there is no real estate asset we hold in collateral that is affected by sanctions and our investments comply with rigorous AML and KYC policies.