Views and opinions expressed reflect the current opinions of the authors only, and views are subject to change at any time without notice. Other industry analysts and investment personnel may have different views and opinions.
Any investment that has the possibility for profits also has the possibility of losses, including the loss of principal.
Please see Key Investment Risks at the end of this paper for additional important disclosure.
Defining Characteristics of Private Fixed Income
As a subset of private credit, PFI is a vast and diverse asset class with an estimated $1 trillion outstanding and approximately $100 billion in estimated annual issuance.1 Its key distinguishing characteristics include:
- Predominantly fixed-rate bonds
- Not SEC-registered (private placements, loans and some 144A securities)
- Primarily investment-grade, although high-yield issuance has been growing due to increased demand and regulatory changes in the US insurance market
Sources: Private Placement Monitor. Data as of 31 December 2023.
This material is for informational purposes only and should not be construed as investment advice Information obtained from outside sources is believed to be correct, but Loomis Sayles cannot guarantee its accuracy. This material cannot be copied, reproduced or redistributed without authorization.
EVOLUTION OF THE PRIVATE FIXED INCOME MARKETPLACE
The evolution of PFI since the global financial crisis has been largely driven by the retreat of traditional commercial bank lenders, which, faced with increased regulation, have curtailed lending to certain market sectors. Non-traditional, private lenders filled the void, and the PFI opportunity set grew to include new sectors and new geographies beyond the US and Europe.
Historically, the private placement space, consisted mostly of investment-grade corporate bonds; however, the past decade saw the emergence first of project finance and infrastructure opportunities and then private asset-backed transactions. In recent years, specialty finance transactions, which typically consist of secured, non-corporate consumer, commercial or esoteric lending, have come to the forefront, offering investors opportunities for additional yield potential and lower correlation versus more traditional private fixed income sectors.
The growth and evolution of the PFI market continues to accelerate, driven by both supply and demand. On the demand side, insurers (historically, the main source of PFI funding) appear to have grown increasingly comfortable with the asset class and turned to it for enhanced yield and diversification potential. On the supply side, more (and increasingly diverse) issuers have sought private markets for reasons ranging from confidentiality to speed and certainty of execution, resulting in a growing variety of deal structures, covenants and collateral sources. We expect this trend will continue, particularly if non-insurance investors increase allocations to this asset class.
Any investment that has the possibility for profits also has the possibility of losses, including the loss of principal.
There is no guarantee that the investment objective will be realized or that the strategy will generate positive or excess returns.
PFI’S VALUE PROPOSITION
We believe PFI’s value proposition for investors rests on three pillars, each of which can be a possible source of excess portfolio return.
PFI’s Role in Insurance Company Portfolios
There are multiple reasons why PFI can play an important role in the portfolios of various types of insurance companies.
First, the PFI universe consists of a range of fixed-rate obligations across a wide duration spectrum, providing the potential for insurers to match both long- and short-dated liabilities alike.
Second, diversity in the issuer opportunity set and transaction structures can give insurers access to a broad and differentiated range of underlying risk factors for their investment portfolios beyond what is available in the public markets.
Finally, covenants may be able to provide both additional lender protections in downside scenarios (higher recoveries vs. public bonds) and potential yield enhancement via fee income. Covenants also help mitigate against the downward migration of credit ratings, which can be beneficial for capital reserve requirement reasons.
CONSIDERATIONS FOR ALLOCATING TO PFI
When considering the role PFI can play in a portfolio, investors should focus on several factors. The following are our key views:
- Yield premia are dynamic. PFI’s yield advantage is comprised of an illiquidity premium and a complexity premium. The complexity premium is typically more constant, being a function of deal structure, while the illiquidity premium fluctuates as market conditions change. Hence, we think it is important to stay invested through the market cycle and avoid attempts at market- timing. Additionally, PFI can offer value through the cycle, not just when illiquidity premiums are high. In our view, it should not be seen as only a yield play. Covenants may be able to provide downside mitigation when it is needed most, and the asset class is a source of significant diversification potential. For these reasons, we believe PFI should be a staple allocation in an insurance company’s portfolio, not an opportunistic play.
- PFI’s liquidity profile may align well with insurers’ balance sheets. Insurers and other liability managers may underestimate the liquidity of the PFI market and overestimate the liquidity of the public bond market. PFI liquidity varies considerably by sector, origination type and other factors. Asset managers with PFI expertise can help investors appropriately size individual investments and make informed decisions about illiquidity risk. Liquidity needs for insurers can also be institutionally supported, if necessary. For example, the Federal Home Loan Bank system, which counts over 400 insurance companies as members, is a reliable and low-cost source of working capital for insurers.
- Focus on the risk exposures and potential return drivers PFI can add to the portfolio. PFI has distinct risk profiles from other alternative asset classes, and PFI and other private assets should not be grouped together into a single “private assets” bucket. One of the primary benefits of PFI is that it can bring a high level of idiosyncratic risk to the portfolio. PFI transactions need to be analyzed case-by-case and evaluated for their correlation with other assets in the portfolio and their impact on overall portfolio risk.
- Determining an appropriate PFI portfolio allocation should be a bottom-up exercise. Peer averages should not be the guiding principle in determining PFI allocations, in our view. This decision should be a function of the many factors that are specific to each insurer. Key variables include leverage, overall asset duration, loss trends on the liability side of the balance sheet and potential liquidity needs under various economic conditions. The evolving regulatory landscape is another factor, given capital reserve requirements. Insurers need to monitor regulators’ ongoing scrutiny of specific deal structures, capital formulae and sourcing of credit ratings. Based on this information, we believe insurers need to evaluate the potential portfolio impacts of regulatory change to determine their appropriate allocations to PFI.
Source: ACLI Life Insurers Fact Book 2022. Data available through 31 December 2022.
This material is for informational purposes only and should not be construed as investment advice. Information obtained from outside sources is believed to be correct, but Loomis Sayles cannot guarantee its accuracy. This material cannot be copied, reproduced or redistributed without authorization.
