Having drawn considerable interest from yield-starved institutional investors in recent years, spurring meaty capital inflows but progressively lower income returns too, the private debt market could be close to peaking.

So thinks Paul Carrett, group chief investment officer of FWD, the insurance business of Hong Kong-based Pacific Century Group, who says it's time to turn more cautious on private credit or at least parts of the market.

“We certainly feel we are in the late stage of the credit cycle and, frankly, are a little bit surprised at how sanguine many players are in thinking they can keep going on like this,” he told AsianInvestor earlier this month.

“Market cycles do eventually end [and], going into this year, one of the pressure points will be the leveraged loans market, particularly around issues around the lack of strong covenants on these loans,” Carrett said.

Sharply in focus in that regard is middle-market lending, which encompasses that segment of the market which is either too small to receive large bank loans or too big for typical small business loans.

"About 80-90% of middle-market lending now comprises covenant-lite loans," Shawn Khazzam, head of the alternatives solutions group for the Asia-Pacific region at JP Morgan Asset Management told AsianInvestor.

Credit rating agencies such as Moody’s Investor Services have been ringing the alarm bells for some time about leveraged loans – which are extended to companies which already have high levels of debt – and the concomitant rise of covenant-lite loans (financing granted with limited restrictions).

Such covenant-lite loans deprive investors of a suite of benefits, including periodic oversight and early warnings of distress. But other protection metrics have also weakened as borrowers push for aggressive terms and capitalise on investors’ voracious appetite for floating-rate instruments.

“While weak loan covenants have dominated the landscape since the end of 2016, it is just one of many factors that do not bode well for loan investors in the next economic downturn,” a Moody’s report issued in October said.

“[The] deterioration in debt cushions is taking debt instruments ratings down with them and is indicative of broader loan market trends that point to weaker recoveries in the next downturn,” it warned, forecasting a drop in the recovery rate to 61 cents per dollar for first-lien term loans compared with a historical average of 77 cents per dollar.

When that downturn will kick in remains unclear, but US middle-market lending has clearly been exhibiting late-cycle behaviour, Carrett said. 

“Whether it’s over-exuberant or not, we are wary of these parts of the market,” he told AsianInvestor.

RATES, ASIA

There is also the question of changing monetary conditions as the US Federal Reserve continues to slowly shrink its bloated balance sheet and raise interest rates, even if talk of a possible pause in hikes later this year has begun to permeate some markets.

Paul Carrett

In broad terms, that will require credit portfolios to be more actively managed.

“In a quantitative easing world, active managers found it hard to distinguish themselves because everything performed well,” Carrett said. “However, as we move from QE to quantitative tightening, investors will have to deal with more volatility, changing economic, political and market cycles as well as rising rates.”

As a result, investors will need to become more selective about the credit opportunities they choose to invest in.

Although investors to date have primarily focused on US and European private credit markets, Carrett noted that Asian private credit opportunities are also generating some interest, including in the Chinese property sector.

But there are still some challenges to overcome when deploying money in Asia or putting teams together, he added.

“European private debt fund houses, for instance, have a lot of experience in sourcing and structuring deals. Doing this in Asia is much harder compared with the US. The legal systems for each nation in Asia are different, for instance, and that can be a challenge when deploying funds,” Carrett said.

Asia-focused private debt funds raised $3.8 billion in the first 11 months of 2018, considerably lower than the $8.7 billion raised in 2017, according to alternatives industry tracker Preqin. Even so, overall assets under management in these funds had an estimated unrealised value of $33 billion at the end of March 2018, while dry-powder capital (funds that firms have available to deploy when good opportunities present themselves) was estimated at $19.6 billion.

About 80% of FWD’s current investments are in government and corporate bonds, Carrett said, without providing a breakdown of its asset allocation or its total investment assets. 

FWD group's assets totalled around $28 billion at the end of September 2018.

*This story has been updated with asset data.

For further insight and analysis into how insurers are seeking to invest and navigate regulatory changes, look out for AsianInvestor's 6th Insurance Investment Forum in Hong Kong on March 12, and our inaugural Insurance Investment Forum in Singapore, on March 14. For more information, please click here.