Q&A: Building reliable income with private assets

High demand and low rates have driven down yields across financial markets. Which areas of private assets are best positioned to generate dependable income in this environment? 

Stephan Ruoff, Global Head of Insurance-linked securities

“Insurance-linked securities (ILS) have always represented what you would call idiosyncratic risk. It remains a risk exposure which is set apart from most other financial markets, especially where it is linked to natural catastrophes, where there is a pronounced decorrelation from economic and market cycles. More than that though, for investors concerned about the policy backdrop and inflation, the implications for both for ILS are minimal. Duration (the sensitivity to changes in interest rates) for ILS instruments is generally negligible. ILS carry floating rates for underlying collateral and coupons are reset annually in many cases.

"Shifts in monetary policy, therefore, make little difference to the instrument’s value, and you are detached from inflation. If you add in the liquidity elements you can find in a cat bond product, or products that have closed-ended structures and provide high yields, you can create risk and income at the same time as diversifying.“

Nicole Kidd, Head of Private Debt Australia

“Australia and Asia are in an unusual position, insofar as the institutional investor is still considered rather unique. The market is trying to create supply to feed the growth of the investment class, similar to what we saw in Europe and the US after the global financial crisis. We also have some unique structures with comparatively low leverage. We are seeing lots of value in the AU$100-750 million total loan size range.

"For larger transactions, we are seeing the terms and conditions being eroded because they are structured with the US term loan B market in mind. We are largely avoiding them, sticking to the areas Australian banks are pulling back from, but where companies are not large enough to access international capital markets. Relative value for senior-ranking broadly syndicated loans is still good in Australia, and offer somewhere in the region of a 1-2% premium, for same average credit risk and lower tenor, and even greater for second-lien or  subordinated instruments.”

Nick Pont, Head of Product Strategy, Securitised Products

“The challenge is really more on relative value, in our view, as absolute value is almost non-existent in traditional liquid fixed income markets. Thus, the question for investors is how do you go down in duration, up in quality and carry, in areas that are untouched by policy? It is doable but one aspect to bear in mind is that we want to be as diverse as we can to be robust to stress, both now and in the future. Finding units of carry versus risk is important.

“We’re focusing client portfolios on being able to allocate where we can be agnostic to sector, geography, capital structure, public or private, etc. Within all our asset classes we can do this, whether it be risk retention, risk transfer, warehousing, to name a few. The lines between credit markets are getting more blurred. Although premium has been compressed, value can still be found if you know where to look.”

Could we discuss the differentiation that some of these asset classes bring to our portfolio construction?

Stephan Ruoff

“A year ago, during the covid-19 crisis, there was a strong response which saw ILS used as almost a cash machine, as the cat bond liquidity was so good. 12-18 months later, what we’ve seen is that there has been some spread tightening in the liquid space. With insurance companies under pressure as losses have driven prices up, another part of the market has now become more attractive.

"Private and longer-term transactions have become a higher focus. We are expanding our offering into private transactions that offer higher yields, sometimes into the double digits, or closed-ended structures that can offer IRRs at around 10-12%. A lot of flexibility in gathering returns is available if you can add both complexity and illiquidity.”

Nick Pont

“Diversification is a characteristic sorely needed in a time of such uncertainty. So many big topics are in play just now: rates, inflation, tapering, growth. I am from the classical school of economics where the greater the level of uncertainty, the greater the remuneration you should get. That risk is not being remunerated right now, so it’s vital to have that ability to oscillate up and down the capital structure and across sectors/geographies. Portfolios with shorter duration, holding instruments that hold hard assets inside them, are valuable, especially where they have a degree of liquidity inbuilt.“

Sustainability is the hot topic at the moment, and there has never been a more critical time to focus on ESG factors when making investment decisions.  How are each of your markets adapting to the increased focus on these themes?

Nicole Kidd

“Sustainability-linked loans are relatively new in Australia and I think the market needs to distinguish between what is real and what is marketing. I’d like to see borrowers incentivised in the form of more generous benefits and margins. Sustainable companies have proven themselves to be less risky and create more value. You could argue that default risk is therefore lower, so we would accept lower margins. To date, the market really hasn’t viewed sustainability as a credit enhancement. We’d like to see pricing being adjusted to reflect reasonable sustainability objectives.

"We need to understand as investors how sustainability affects both short-term cash flows and the long-term viability. We have spent a lot of time thinking about it and talking to potential borrowers about how they are managing it before we take any further steps in investing in a loan instrument. We’ve spoken before about a “hospitality mindset” in real estate, and in loans it is much the same. It’s not just about lending money, it’s a strategic partnership to invest and support our companies, bringing together the synergies that institutional capital can bring to those credit-worthy borrowers."

Nick Pont

“The sector we are in is consumer-based finance. Access to credit for consumers is vitally important. If you can line up your capital in a sustainable way, you’re going to get a more sustainable outcome. Whether it’s commercial real estate looking to upskill an area, or provide access to consumer credit, it all comes back to the consumer. Governance matters and we need to be quantitative and qualitative in gathering data and deciding what sustainable investment really means.”

Stephan Ruoff

“Insurance has quite a high score when it comes to social benefit. We can use an example such as Hurricane Ida, and the strength of insurance solutions to provide financial relief in recovery. It illustrates the social strength but also highlights the environmental. Climate change is obviously in our minds and we need to build it into investment processes. How do we build the environmental element in? Knowledge in catastrophe modelling is essential. As is the disclosure level, allowing us to be sure what we are investing in.

“We are listing several funds under the SFDR article 8. It’s European-led regulation, but since its introduction in March, we have travelled a long way. We’ve tried to build a whole new framework around our investment process, which started with the mission statements of the funds we provide. We have adapted some of those mission statements to include ESG criteria, and then built a binding framework that governs the investments we hold; what risks will we accept, how many of the investments that we provide contribute to a protection gap? We are also adding exclusions to make sure certain risks don’t appear in our portfolios. On one hand, the funds meet the SFDR article 8 requirements, but the changes apply globally, not just in Europe.”

This article is issued by Cazenove Capital which is part of the Schroder Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.

Contact Cazenove Capital

To discuss your DFM requirements, or to find out more about our services and how we can help you, please contact:

Nick Georgiadis

Nick Georgiadis

Head of DFM Team nick.georgiadis@cazenovecapital.com
Simon Cooper

Simon Cooper

Head of DFM Relationship Management simon.cooper@cazenovecapital.com