1. Is there risk of regulatory change occurring which changes the attractiveness of opportunities?
Infrastructure is one area where regulatory considerations can come into play. Where one is investing in debt, which consists of a contractual stream of cashflows from an entity there are likely to be two ways in which regulatory change could affect this investment. Firstly, the risk that similar financing becomes available to the borrower at more attractive rates and they will prepay the loan (see Q 5 below). Secondly there is the risk that a regulatory change may alter the credit quality of an investment (removing implicit government support perhaps). We would tend to steer away from investments where this is a material risk, but ultimately would expect the fund manager executing and managing the trade to make the decision.
2. Is now the right time to buy – will opportunities improve once the European "Wall of Maturity" hits?
We've seen a successful example of a similar "wall of maturity" being rolled out in a relatively orderly fashion in the US. Of course there is always the possibility that a disorderly situation could occur creating the opportunity to buy distressed assets. This is one area where we believe choosing a skilled and experienced fund manager is key as the precise timing decision is effectively outsourced to the manager who is best positioned from both an experience and governance viewpoint to make that decision.
3. Are most of the bonds floating or fixed coupon, how would this relate to a pension scheme flightplan expressed relative to gilts?
Historically many of these loans were made by banks, in a floating rate format, and this was often to suit a bank's funding profile, and were often accompanied by issuer swaps which left the borrower effectively paying a fixed or even inflation linked rate. The opportunities in illiquid credit are therefore a mix – many of the longer dated opportunities will be available in a fixed or inflation linked format, which can be assessed in a gilts-plus framework, but the bulk of the shorter dated lending market remains LIBOR focused. For these shorter dated opportunities, such as CRE debt or direct lending, an absolute return mindset may be more instructive for assessing the relative value of opportunities, given the extremely low level of LIBOR.
4. How should these asset be marked on the books (to what extent should/can they be marked to market)?
This is a key question in the case of illiquid credit investments. The fact that the investment is not intended to be sold in the short term should not detract from the need to place as realistic as possible a value on it, also there is likely to be some regulatory/legal requirements to mark to market where this is possible. The details around this will be the domain of the fund manager running the investment. For some of the sub-classes of illiquid credit there will be liquid observable benchmarks, such as indices or tradable bonds which the manager can use to mark their portfolio to if they move. Using a combination of liquid observables and comparables, we believe it should be possible for managers to place an accurate market value upon these assets, despite the lack of a liquid market for them. Generally we would be expect managers to take a robust and conservative-leaning approach to valuing the portfolio.
5. How should these assets be risk modelled?
The risk modelling varies depending on the individual opportunity type. We typically use liquid market equivalents in order to assess the risk of these investments, with the caveat that some of the ideosyncratic risks faced, for example in infrastructure, can be difficult to quantify and incorporate. The financial market risk of the investments can be approached by modelling the characteristics of the cash inflows from the investments in terms of the timing, quantity and certainty of the cash flows. Redington has experience of working with asset managers using a bottom up approach to model the investments based on individual positions and holdings in the actual client portfolio. We know from experience of working with fund managers that our approach to risk modelling these positions is generally considered to be extremely conservative.
6. Does prepayment risk change the attractiveness of opportunities and how can this be dealt with?
Many of these opportunities, particularly the floating rate loans, carry a degree of prepayment risk. Where these arise, they are best addressed by tight wording in the contractual documentation, and significant penalties applying in the case of prepayment – it appears that borrowers will generally agree to some degree of prepayment penalty.
Long lease investments bear a minimum level of prepayment risk as investors own the properties outright and are exposed to risk of tenant default. In the case of infrastructure debt, the prepayment rate has been historically low for structural reasons, and prepayment penalties are common within the loan structure. CRE loans typically have a graduated prepayment fee for the first few years of the loan. Substantial prepayment protection for loans in excess of 10 years are possible but only limited opportunities are available in the CRE lending market for these long-dated loans.
7. What's the geographic split of the lending portfolios and what approach is taken with regard to currency hedging?
The geographic split will vary quite a lot depending on the sub-class of the illiquid credit universe. Specifically, Infrastructure debt, CRE debt and long leases can all be acessessed satisfactorily in Sterling denomination. Direct lending and distressed debt portfolios are likely to have a more international focus and therefore some currency hedging may well be required, depending upon the investor's attitude to currency risk. We would typically assess the likely collateral drag of this ongoing hedging on the returns available in order to provide a fair comparison between the various different opportunities.