Investing in Private Debt: Some Thoughts on Credit Quality, Default Rates, Realised Losses and Yield Spreads
By Stephen Johnston
A clear understanding of credit quality as it relates to default rates and yield spreads is critical in evaluating the wide variety of private debt offerings in the exempt space – offerings that range from industrial equipment leasing to MICs.
The purpose of this brief article is simply to raise some questions that should be considered when a private debt investment is being contemplated. In the same fashion that volatility and correlation were rarely discussed in the exempt space five years ago but are common analysis today, we expect the analysis of expected default rates and yield spreads to be an area that will see increased sophistication in the coming years.
It is not an infrequent occurrence in the alternative space to be told that investment X is yielding 11% for a 3-year term, and investment Y is yielding 7% for a 3-year term so investment X must be better for clients without sufficient analysis of the underlying credit quality and default risk – even when the investments are in the same asset class and such comparisons are more straightforward.
In the simplest terms, as an investor, you are evaluating 1) the risk that your private loan will be repaid in full and then 2) whether the yield you are being paid compensates you for the excess default risk as compared to a risk free investment of the same duration. In other words, what is the risk of loss and what are you being paid to accept that risk.
The challenge in the alternative market is sometimes a lack of historical default data for the underlying investments as many exempt issuers are blind pools or have short operating histories. Fortunately, rating agencies maintain large databases of default data broken down by credit quality, industry, sector, year etc. from which useful insights can be drawn.
One powerful observation from rating agency data is not that default rates increase as credit quality goes from high to low, but more importantly that this change is non-linear – by this I mean that moving from high quality to low quality credits typically increases defaults at an ever increasing rate. In the chart below, moving from AAA to CCC increases the expected default rate over 100 times.
Chart 1: Cumulative Historic Default Rates (% left axis) with Indicative Corporate Yields by Rating (% above bars)
Sources: St Louis Federal Reserve, BofA Merrill, Moody’s, S&P
Of course, this non-linearity does not present a problem in and of itself when properly priced and managed, but I would argue that while the range of credit quality in the underlying investment portfolios of exempt issuers is quite wide, the spread of yields may not be properly reflective of this variance – i.e. the exempt market may not yet be properly pricing default risk in the form of additional yield or structural enhancements. Take for example two potential investments in two corporate loan portfolios (an asset class with large amounts of historical default data):
Portfolio 1 - focused on “A” credits (borrowing rates of approximately 6% and lower)
Portfolio 2 - focused on “C” credits (borrowing rates of approximately 15% and higher)
To put these two portfolios into perspective, according to historical data from Moody’s and S&P:
“AAA” loans typically default at approximately 0.6% with recovery rates around 70% = 0.2% loss rates on average
“CCC” loans typically default at approximately 70% with recovery rates around 60% = 40% loss rates on average
Given this loss data, which reflects the distinctly non-linear increase in defaults as credit quality decays, all other factors being equal, one must ask: Is an investor properly compensated for investing in the 7% 3-year security versus the 11% 3-year security? Does 400 basis points (bps) of additional yield compensate for the additional losses the “C” credit portfolio will experience?
Another important pricing consideration is how differing quality credit portfolios behave during a change in underlying market/economic conditions. During a recession an AAA portfolio might become an A portfolio which, due to the non-linear change in defaults rates, results in a modest change in aggregate write-offs while a BBB portfolio might become a CCC portfolio completely eroding the benefit of the additional original yield, and perhaps raising the threat of significant capital loss.
I would also argue, given the larger probability of individual defaults, lower credit portfolios must be highly diversified to take advantage of the law of large numbers. Undiversified portfolios of lower credit quality investments may deviate significantly from historical defaults rates with possibly good or bad consequences but ultimately this merely represents increased volatility which is risk for which the investor must receive additional compensation over and above the already high yields that such portfolios should provide, meaning that: with all other factors being equal, a less diversified portfolio of lower credits should attract even higher yields than a more diversified portfolio of the same credits.
Mr. Stephen Johnston is a Co-Founder and Partner at Agcapita Partners LP. Previously, Mr. Johnston was the Head of the Societe Generale Asset Management - Emerging Markets United Kingdom, where he was the Head of the Private Equity Team responsible for closed-end funds covering the Baltics, Central and Eastern Europe, and the Middle East with almost C$ 500 million under management. He has over 18 years’ experience as a fund manager from both the private equity and debt markets perspectives. Mr. Johnston has been featured on radio, TV and print media including CBC Business News, BNN, Fortune Magazine, Rolling Stone, the Financial Times, the Globe and Mail and the Wall Street Journal. Mr. Johnston’s monthly investment briefings are now read by almost 20,000 subscribers. Mr. Johnston received an M.B.A. from London Business School in 1994. He also received an L.L.B. in 1990 and a B.Sc. (honours) in Biology in 1987 from the University of Alberta.
 Moody’s Investor Services – Credit Loss Rates on Similarly Rated Loans and Bonds – Dec 2004