Why Does Total Return Matter in Private Credit?
July 14, 2017 | Total return is the measuring stick many investors use to determine how their asset managers are performing over time. Although total return is more difficult to track for private credit offerings than it is for public bonds, the performance metric is arguably more important in the private market. This is because private holdings have different sources of non-coupon income to consider, such as up-front yield premiums.
While we believe private credit represents an important component of broader fixed income portfolio strategy, industry data for this asset class is limited. To help investors make more informed decisions, we used the 10-year historical return and risk data for the Voya Private Credit portfolio to break down the three factors that drive excess total return in the private credit market (note: Voya’s performance data may or may not be representative of the larger private credit marketplace and should be considered for educational purposes only).
The excess total return for Private Credit is driven by three items:
- A premium in the up-front yield - also known as a “spread to publics” or STP
- Prepayments and amendment/waiver fees
- Lower actual credit losses in the event of default
Spread to Publics premium
Issuers are willing to pay more to issue private debt. Why? Because of customization. For example, privately-issued debt has a variety of unique characteristics that are valuable to issuers, including tenures not issued in the public market (e.g. 12 or 15 year), customization of tranche sizes (e.g. $120 million, $50 million, and $100 million issued in different tranches), amortizing bonds, floating-rate notes, delay draws, non-USD swapped offerings, etc.
Using Voya’s data, the last ten years shows that the historical average of the up-front yield advantage on individual private deals compared to similarly rated and similar duration public bonds is about 75 basis points (bps). This premium is achieved due to the customization offered in private credit bonds as opposed to actively trading a public bond portfolio to generate alpha.
Covenant protection drives non-coupon income and lower losses
Private Credit deals are typically longer than bank lending (i.e. 5 to 30 years), which is why deals include covenant protection. Covenants can provide non-coupon income and are crucial to avoiding and minimizing loss when defaults do occur. Broadly speaking, the covenants provide the lender with the ability to re-price or put back the loan to the company if risk in the company changes substantially.
Analyzing Voya’s 10-year track record reveals two key points. Not only did the covenant protection and the workout/restructuring expertise of the asset manager drive prepayment and amendment/waiver fees (27 bps on a diversified portfolio), it also lowered losses (typically an additional 19 bps annually).
Total return benchmarks for Private Credit
Choosing a benchmark for the total return calculation is important to compare equivalent investment options. However, there is no index for Private Credit. The best option is to compare performance against public corporate indexes (e.g. Bloomberg Barclays Corporate index), as the credit exposure in these indices is similar to investment grade private credit. However, the index must be adjusted to match the duration of the private assets, which is typically about 5-6 years for a mature, continually investing portfolio. [Note: the portfolio duration for a new investor in private credit would be closer to 8-9 years]. Once the private credit duration is matched with the duration of the public bond benchmark, the performance of both credit exposure – whether private or public - can be compared.
As demonstrated in Figure 1, over longer time periods, private placements have outperformed a public bond index of similar duration with less risk (as measured by standard deviation).
Comfort with Spread to Publics Calculations
For most investors, there is probably little concern around the calculation of prepayment fees, amendment fees, and losses. However, the “spread to publics” is the item most open to interpretation because it is defined and tracked differently by private credit teams across the marketplace. Some teams compare the private offering to a liquid public bond and use that as the “spread to publics.” Other private credit teams compare the private offering to a sector index spread or overall industry index spread. Therefore, tracking total return is important in Private Credit because without it, it is hard to determine if the asset manager’s stated spread to publics is genuine. Also, private credit is a buy and hold asset class so it is important to look at total return over an investment cycle (or about 10 years) as this would effectively capture both the front- and back-end income from private credit offerings.
For example, Voya Private Credit team’s total excess return over the benchmark over the last 10 years has been approximately 122 bps (gross of fees). This substantiates the sum of Voya’s average annual 75 bps spread to publics + 27 bps for prepayment/amendment fees + 19 bps for lower losses = 121 bps total additional income. Without the full context for total return and actual historical performance, it would be hard for an investor to trust the spread to publics calculation because there is room for human influence.
By understanding the different components of total return, we believe potential investors in the asset class can better evaluate each private credit manager’s investment approach and performance track record, as well as gain a more comprehensive picture of the potential sources of risk in a private credit allocation.
Figure 1: Public vs. Private: Private Credit Has Delivered Better Absolute and Risk-Adjusted Returns
Source: Voya Investment Management, Barclays Live. Represents 10 years ending March 31, 2017. Composite performance is based on the Voya Private Credit Investment Grade composite. Bloomberg Barclays U.S. Corporate Duration-Adjusted Index is the U.S. Corporate Index published by Bloomberg Barclays that is adjusted to have duration identical to that of the Private Credit portfolio.
This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) changes in laws and regulations and (4) changes in the policies of governments and/or regulatory authorities. The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors.
The historical total returns are generated from proprietary insurance private debt holdings that as of December 31, 2014 have a market value of $16.6 billion in AUM. Returns are before the deduction of management fees and will be reduced by advisory fees and other fees incurred in the management of the portfolio. For a description of advisory fees, please see Form ADV, Part II. Historical return is based on the performance of the Voya IM Private Credit portfolio through December 31, 2014. The performance presented is based on portfolios managed for our proprietary insurance assets. These assets fall outside of our GIPS firm definition and therefore not subject to the input, calculation, presentation, and disclosure requirements of GIPS. Gross-of-fees returns are calculated on a monthly basis by taking market values which use a spread pricing process and contain cash flows that are inclusive of regular P&I payments, coupon payments, including the impact of coupon bumps, amendment and waiver fees, and prepayment premiums and then geometrically linked the results to produce annual returns shown. The annual management fee will vary according to the size of the account, and will depend on the type of investment vehicle selected. The performance above is offered as Supplemental Information only. Performance shown for less than one year is not annualized. Further information regarding applicable fee schedules is available upon request.