Does a slowing economy increase the risk of loan defaults in private debt?

Well-run private debt funds use rigorous scenario testing and real-time monitoring to mitigate risks. Historical net write-offs by banks peaked at just 0.68% during the GFC and were 0.04% in September 2024, demonstrating strong resilience across economic cycles.

Does a loan default always result in a credit loss?

No. Private debt investors are protected by their seniority in the capital structure. Senior debt holders get repaid first, before subordinated debt, preferred equity, and common shareholders. Covenants and controls act as early warning signals allowing lenders to engage with borrowers to mitigate financial loss.

Are all private debt managers the same?

No. Private debt managers differ significantly in scale, credit skills, and experience. Quality managers need sizable assets under management, bank-level credit skills, extensive networks, and the ability to directly originate and diversify loans across borrowers to achieve optimal outcomes.

Does commercial real estate debt put capital at risk in a property downturn?

Property owners face greater risk than lenders. With typical loan-to-value ratios of 60%, owners' equity acts as a buffer. Even if property values fall significantly, lenders can compel borrowers to restore their position or pursue asset sales to maximize recovery without necessarily incurring losses.

Are non-bank lenders lenders of last resort?

No. Competent private debt managers lend to quality companies and often compete with banks or work alongside them in lending syndicates. Post-GFC regulations requiring banks to hold more capital have created financing gaps that private debt fills for established companies with sound fundamentals.

Harnessing capital structure as a crisis buffer

With many income investments no longer offering the downside protection they once did, nestegg has taken a look at an alternative form of investment: corporate loans.

According to Metrics Credit Partners’ managing partner, Andrew Lockhart, investors of all sorts should currently be revisiting and gaining a better understanding of where investments sit in the capital structure, and the roles that they can and can’t play in generating returns.

Investments that are senior in a company in a company’s capital structure and rank ahead of equity will result “in less volatility and lower correlation to equity markets”, Mr Lockhart said.

Giving an example, the managing director raised how “regardless of conditions in equity markets, Australian corporates still have to borrow and refinance their loans and continue to pay interest on debt owing”.

Corporate loans are lower down the risk spectrum than growth assets such as equities because they come with a range of embedded protections, he outlined, explaining that they are generally secured by the borrower’s assets, and lenders are paid before equity holders in the event of business insolvency.

Corporate loans are made to businesses of scale for a specific purpose – whether it be working capital, real estate, capital expenditure or acquisitions.

Due to nature of such loans, they can provide investment exposure across a range of industries – from industrials to consumer staples, healthcare, IT and commercial real estate.

“As such, an investment in defensive asset classes such as corporate loans have historically provided an important source of downside protection and attractive alternative sources of income in previous downturns,” he stated.

And while preserving capital is a key priority for pre-retirees and retirees alike in a downturn such as the COVID-19 crisis, Mr Lockhart also emphasised the ability of corporate loans to provide an important source of income.

This is derived from the interest that corporate borrowers pay, he said, and can offer “attractive income returns” due to being slightly higher up the risk curve than government bonds.

The subset of fixed income generated from interest payable and fees is classified as a defensive investment, as its structure naturally contains embedded protections such as covenants, controls and security over the underlying asset.

“For those investors who require liquidity, an investment in an ASX-listed fund providing exposure to a diversified corporate loan portfolio can provide daily entry and exit – with income paid monthly,” Mr Lockhart offered.

He added that corporate loss rates are low, averaging just 0.32 per cent over the past 10 years.

“With the fall and continued volatility in equities markets, we believe corporate loans warrant a closer look for investors seeking downside protection,” the managing partner concluded.

Grace Ormsby, nestegg – 1 May 2020

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