Investment Grade Private Debt

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Market Insights and Opportunities 

Over the years, private debt has emerged as a significant asset class, offering unique opportunities for investors seeking yield and diversification. This asset class is, however, much broader than sub-investment grade private credit, which is often – for good or bad reasons – under the spotlight. Over time, iAGAM has developed strong expertise in private debt investing and now has more than CA$6 billion invested in private debt securities. The purpose of this white paper is to address the opportunities on the other side of the market landscape: the investment grade private debt market.

1. A market traditionally geared to long-term opportunities

The investment grade private debt market emerged decades ago, when life insurance companies sought high-quality, long-term assets to align with their liabilities and reduce their capital charges, and issuers looked for long-term financing that banks couldn't provide, owing to their shorter liabilities. Unlike the better-known sub-investment grade private credit, investment grade private debt is used mainly by insurance companies for asset-liability matching (ALM); thus, its characteristics are shaped by the ALM function.

Issuances are generally long-term (sometimes in excess of 30 years) with fixed rates and non-callable structures, as well as make-whole provisions to protect bondholders in case of early prepayment. Issuers are generally companies that operate in defensive, non-cyclical sectors or have projects with stable and predictable cash flows, such as infrastructure. More recently, the market has integrated shorter, higher-yielding issuers, such as asset-backed securities and business development companies to address the need for higher yield.

Unlike the public investment grade bond market, the private investment grade debt market is mostly a primary market (i.e. investors rely on new issuances to put their money to work). Even so, there is a secondary market that was estimated at US$4 billion last year, a figure much lower than the new issuances total of US$150 billion.

Consequently, successful deployment requires more than capital; it demands access. Having forged a strong network of brokers and agents, combined with a focus on business development and relationship building with sponsors, iAGAM is well positioned to source and execute opportunities effectively.

2. Issuers with predictable cash flows

One main feature of the investment grade rating is that such issuers have a lower probably of default, often as a result of highly predictable cash flows and appropriate debt sizing. Typically, they issue project-finance bonds, corporates, infrastructure bonds and structured products.

Predictable cash flows are achievable for projects that use proven technology and involve counterparties, owners, operators and constructors who possess the necessary expertise and financial resources. Generally speaking, all construction risks are passed on to other stakeholders. Examples of projects issuing in this market are publicprivate partnerships with availability-based payments, such as projects for the construction and operation of toll roads, hospitals or other essential infrastructure, and renewables projects that have long-term power-purchase agreements with strong counterparties.

Typical corporate, non-project-finance issuers include infrastructure and non-cyclical companies. Examples of infrastructure are utility lines, airports and ports with strong fundamentals. Stringent regulation, essential services, outreach to a large population, and conservative financial metrics are common to this type of issuer.

Another type of vehicle is structured products, which are typically organized into multiple tranches, each offering varying levels of risk and return. Senior tranches are prioritized for repayment, ensuring lower risk, whereas junior tranches are riskier but offer the potential for higher returns. These structures allow investors to select tranches that align with their risk appetite. Even though such transactions usually have a shorter term than traditional investment grade private debt and often serve as a returnseeking asset as opposed to having an ALM function, there are also longer-term transactions, such as ground leases with subordinated zero-coupon tranches.

3. Premium and diversification

From an investor's perspective, investment grade private credit offers a liquidity and structure premium along with diversification benefits. For foreign investors, the highly predictable cash flows from these bonds allow for more efficient hedging with cross-currency swaps rather than forward contracts. This asset class complements an investment grade public bond portfolio for investors who can tolerate its illiquidity characteristics.

Structured products further enhance portfolio diversification by encompassing various sectors, underlying debt types, risk level, countries, interest rates, and maturities. They present a complex yet rewarding investment opportunity, balancing risk and return through innovative financial instruments. 

4. Confidentiality and customization 

From the borrower's perspective, private markets offer confidentiality, customization, and diversification of its investor base.

Confidentiality is a key feature of private debt, because companies do not have to publicly disclose their financial information. That said, investors usually have access to such information when they purchase a bond and until its maturity.

Structured products are highly customizable instruments designed to provide credit to borrowers with intricate financing needs while safeguarding lenders' interests. These contracts incorporate specific mechanisms tailored to a company's cash flow profile and asset base, aiming to protect investors and optimize financial outcomes for borrowers. 

5. Understanding the risks and protections

An investment grade rating does not guarantee quality, and not all BBBs are equal. Investors must conduct thorough research to avoid negative surprises, especially because they will be locked into their investment for decades. In all transactions involving iAGAM, the base case assumes the issuer will have sufficient funds to repay its debt through normal operations. Even so, many unforeseen events can occur over the life of a bond, making it crucial to have contingency plans. Structuring will include appropriate reserves, covenants, structural seniority and guarantees:

• Reserves help issuers navigate temporary liquidity crunches, such as during Covid or a drought.
• Covenants help build early lenders’ trust and ensure that borrowers consider their interests.
• Structural seniority incentivizes other stakeholders to step in and repay senior lenders or allow lenders to be closer to key assets.
• Guarantees align borrowers’ and lenders’ interests, while protecting lenders from losses.

As for structured products, a thorough understanding of the quality and nature of the underlying assets is vital because their performance directly affects the stability and reliability of cash flows. To strengthen transactions, originators use credit enhancements, such as overcollateralization, reserve funds, and subordination, to add additional layers of protection against default. Efficient credit enhancements can significantly mitigate risk and improve a security’s credit rating, making it more appealing to conservative investors. Market conditions can profoundly influence the performance of structured-finance products. A favourable economic environment tends to enhance the appeal of such investments, because lower interest rates can improve borrowing conditions and increase the value of underlying assets. That said, during periods of economic prosperity, investors may become overconfident, leading to borrower-friendly structures that can expose investors to significant losses if economic conditions deteriorate.

The concepts of structure degradation and covenant-lite have been prevalent in all private debt submarkets for several years, mainly because of increased competition among lenders. Although structures in investment grade private debt have degraded in some sectors relative to a decade ago, they have stabilized, and competition among lenders is now seen mostly in pricing and allocation rather than structures and covenants. The requirement to receive an investment grade rating limits the ability of issuers and agents to stretch structures further.

6. Performance of the asset class in contexts of market volatility

Private markets are often said to be shielded from market volatility, given their low correlation with public markets. But this is only partially true for investors in the investment grade private debt market who mark each bond to market on a daily basis according to public comparables, capturing the everyday volatility of the public corporate bond market.

That said, a large portion of the market has a lower default rate and a higher recovery rate than typical corporate bonds with the same rating. A case in point is infrastructure, which accounts for a significant portion of investment grade private credit. The essential nature of such services and their high barriers to entry make such investments more resilient to credit migration.

Investment grade private debt has lower correlations in terms of credit rating stability, with credit migration being mostly asset-specific rather than linked to cycles. In a few subsectors, there are correlations between issuers affected by the same factors, such as hydrology affecting hydro facilities in the same region or utilities subject to the same regulation. Aside from these specific factors, the credit quality tends to be idiosyncratic. The current volatility should exemplify this rating stability, as many issuers are expected to fare well despite tariffs, uncertainty, and potential inflation.

Although infrastructure such as ports, airports and toll roads could see its investment thesis and economics change fundamentally in the coming years, many other types of infrastructure will be much less affected. Renewables projects with long-term indexed powerpurchase agreements with solid counterparties should remain stable.

As has been seen numerous times, volatility has a strong impact on deal flow. Many investors invest on the basis of relative value in relation to the public corporate bond market. When volatility is high in the public market, pricing a transaction becomes more challenging, and issuers may decide to wait until the market stabilizes.

Investment grade private debt presents a compelling investment opportunity, offering a premium to public bonds, diversification, and stability for investors looking for high-quality, long-term returns. By staying attuned to market trends, and maintaining disciplined structuring and risk management practices, investors can navigate the complexities of the investment grade private debt landscape and capitalize on its potential.