Private debt offers some attractive recession-proof features but investors need to take care with more rigorous “downside analysis”, according to a new Schroders Capital analysis.
The Schroders paper says the floating rate nature of most private debt agreements shields investors from interest rate risks but with a potential recession looming, assessing loan quality based on granular metrics remains paramount.
“Rather than thinking purely about top-down sector exposure, cashflow lenders’ attention should primarily focus on cashflow resilience of individual borrowers. In any sector you will have businesses that will perform well and have more stable and resilient cashflows, and ones that will not (leaders v. laggards),” the analysis says. “Any investment considered in the current environment will have an even higher degree of downside sensitivity testing (both in terms of interest rate and other macroeconomic factors) applied to ensure that over the life of the loan, the cashflows are resilient enough to be able to manage debt serviceability without major pressure.”
Nonetheless, companies in some ASX sectors such as healthcare and infrastructure tend to hold up better during recessions than IT, construction or real estate – although private debt opportunities remain across the board.
Schroders head of private debt APAC, Nicole Kidd, said in a release that investors in the asset class have already benefited from the uplift in interest rates and “adjustment to credit margins” as economic conditions tighten.
But Kidd says “success in this uncertain environment comes from ensuring [private debt investors] are investing into better quality risk profiles and being compensated for that risk with higher spreads”.
“So, for appropriately structured debt where there is enough cushion to buffer cost and revenue pressures, the borrower should be able to continue to meet its interest obligations. These factors make this asset class appealing in the current changing macro backdrop,” she said.
“Borrowers are currently facing a multitude of pressures, however good private debt mangers know how to stress test for them and, via a focus on diversification within portfolios, can find the best-of-breed names in sector classes.”
The report says environmental, social and governance (ESG) factors such as climate change and biodiversity risks are growing in importance for private debt investors in line with listed assets and the wider fixed income markets.
Businesses that have not begun transitioning for a low-carbon environment could face higher-priced debt, for example.
“Similarly, industries which have breached or are out of favour from a social and governance perspective, such as mining or casinos, could also expect higher priced debt,” the paper says.