At the eye of the storm during the financial crisis, debt markets have more recently been broadly characterised by one factor; a chronic lack of yield. A historically unprecedented campaign of quantitative easing by the central banks pushed debt prices up and yields lower, even as suppressed interest rates eliminated the value of cash, according to Andrew Jackson, Head of Fixed Income at Hermes Investment Management. Although prices should in theory fall as quantitative easing is slowly reversed over the next months and years, that process will be painfully slow and so is unlikely to relieve the pressure any time soon.
The absence of yield has driven investors to consider ever-more-esoteric areas of the debt markets, as they seek the elusive illiquidity premium that would have once benefitted them, which has all but been eliminated for some private assets due to this paradigm. Simply put, investors are not being compensated for the risk they are taking on. Elsewhere, investors have been forced down the more liquid capital structure of businesses or of the rating spectrum, taking on more risk as they hunt for yield.
As this story has evolved, the opportunity set has narrowed in both liquid and illiquid debt, with rising prices suppressing yields further. However, there are significant pockets of opportunity that we believe the markets are overlooking where the illiquidity premium is still present and growing. These are fundamental, secular opportunities, which should be resilient against the future market cycle.
One of the most significant factors currently influencing debt market valuations is regulation. Traditionally significant buyers, such as banks and insurers, are now prevented from holding certain asset classes, presenting a clear opportunity for smaller investors to buy mispriced assets. For example, real estate debt and direct loans to small-and medium enterprises are both very attractive, which could be sustainable sources of yield in the years to come.
Structured credit is another area of the market where regulation has impacted the asset class. Solvency II means that insurers, that used to hold structured credit in bulk, can hold only very distinct areas of the asset class. Insurers appear limited to triple-A rated structured credit, which is a very small proportion of the available pool of assets.
Emerging market debt
Emerging market debt is still attractive. The distinction between emerging and developed markets is becoming increasingly blurred, more so than it has ever been, particularly given the condition of some peripheral European countries. There are clear possibilities in the blue-chip end of those markets and we see many Emerging Market based companies having global franchises and being exposed to Supra-jurisdictional macro trends rather than specifically those of their home sovereign. In fact investor behaviour that is driven by looking at Emerging Market corporates purely through their jurisdictional lens is likely to give rise to opportunities to buy the babies thrown out with the bath water.
Real estate debt
Real estate debt is an asset class that has been incredibly resilient despite significant macro-economic volatility. Brexit concerns, major elections across Europe and the changing investor landscape have been challenging but underlying property values have been supported by reasonable occupancy and rental yields in the major cities. The reduced likelihood of a major Europe-wide recession appears to have lessened some of the concern that large tenants may have had over committing to long term contracts yet opportunities still persist. An excellent understanding of the drivers behind the broader real estate market, structural and legal analysis coupled with access to the less vanilla and trophy transactions are the key drivers behind finding value and in the hunt for yield.