In our latest real assets deep dive, our research team crunches the data to see how evolving macro conditions are reflected in private debt returns.
Read this article to understand:
- How the current macro environment is reflected in private market illiquidity premia
- Drivers of debt activity and demand over the past 12 months
- The opportunities across private debt asset classes
“It is a capital mistake to theorise before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts...” So said master detective Sherlock Holmes in Arthur Conan Doyle’s story “A Scandal in Bohemia”.
It will be no surprise to learn that we on the real assets research team agree with the sentiment. Accurate and timely data is a vital starting point for investment decision-making. As a large lender in private markets, Aviva Investors has access to a pool of proprietary data that we can use to analyse market trends and inform our strategies.
In private debt markets, illiquidity premia are a key factor in assessing relative value between private sectors as well as versus public debt markets. For investors who can provide long-term patient capital, these premia represent the potential to harvest additional returns from investing in private debt, whilst also enabling investors with a multi-asset or opportunistic approach to take advantage of relative-value opportunities between private debt sectors and pricing dislocations versus public markets.
Our dataset and illiquidity premium measurement approach
Our dataset encompasses over 2,000 transactions over a 25-year period. It covers sterling and euro investment-grade (IG) deals only, covering mostly internal transactions but also external transactions where we were able to obtain pricing data.
The illiquidity premia output captures the spread premium over the most relevant reference public debt index (ICE BofAML index data) at the point of transaction, represented as dots in Figure 1. The illiquidity premium represents an additional spread (which is not always positive) over public debt markets to compensate for increased illiquidity and/or complexity risk.
Figure 1 also includes the discrete calendar-year average illiquidity premium which equally weights the underlying transaction data.
The key risk warning of this output is that the calculated illiquidity premia are rating-band (not notch) matched and are also not duration/maturity matched to the relevant reference public debt index. Therefore, the illiquidity premia shown are indicative.
Figure 1 shows that over 2023 illiquidity premia improved across all private debt sectors. Supporting factors in this trend included the expectation that developed market central banks were approaching the end of their interest-rate hiking cycles and growing optimism surrounding the likelihood of a “soft landing” outcome, which has moderated spreads on comparable public debt.
We also note that real estate debt illiquidity premia improved towards the end of 2023, in line with expectations underlying real estate valuations were showing signs of bottoming out, especially for thematically resilient sectors such as living and industrials.
Figure 1: Illiquidity premia in private debt to December 2023 (basis points)
Past performance is not a reliable indicator of future returns.
Note: For illustrative purposes only. The value of an investment can go down as well as up and there is no guarantee that the forecasted return will be achieved.
Source: Aviva Investors, ICE BofAML index. Data as of December 31, 2023.
The key takeaways we draw from this data are:
- Illiquidity premia are not static and vary through the market cycle.
- Illiquidity premia across the various private debt sectors do not travel uniformly and have various dynamics through market cycles.
An important driver of the varying pricing dynamics across private debt sectors is the “stickiness” of private debt sector spreads versus public debt.
- Real estate debt spreads tend to be the most “sticky”, resulting in illiquidity premia that have historically been correlated to the real estate cycle. Real estate debt illiquidity premia tend to compress when real estate capital values decline, and then typically recover as real estate valuations rise.
- Infrastructure debt spreads tend to be moderately sticky, and re-price more gradually to public debt markets.
- Private corporate debt spreads tend to be the least sticky and re-price the fastest to public debt markets. Given this dynamic, illiquidity premia tend to remain in a narrower range over the long term. Also, some of the highest illiquidity premia have occurred during periods of higher market volatility, especially when there is reduced availability of capital from more traditional lending sources.
As a result of these factors, private debt sectors have various pricing dynamics over the economic cycle, as outlined further in Figure 2. Therefore, when investing in private debt a multi-asset approach can be beneficial and allow investors to take advantage of such relative value pricing opportunities between sectors.
Figure 2: Pricing dynamics across private debt sectors
| Private debt sector | Private debt spread dynamics | Market stress/rising public spreads |
|---|---|---|
| Real estate debt | Most sticky/slowest to reprice versus public debt | Illiquidity premia typically squeezed the most |
| Infrastructure debt | Moderately sticky versus public debt | Illiquidity premia typically squeezed |
| Private corporate debt and structured finance | Least sticky/quick to reprice versus public debt | Illiquidity premia can increase during periods of market stress |
Past performance is not a reliable indicator of future returns.
Note: For illustrative purposes only.
Source: Aviva Investors, ICE BofAML index. Data as of December 31, 2023.
Looking forward, we believe private debt sectors should continue to generate attractive illiquidity premia in the coming months given the restrictive lending environment from more traditional sources of capital. Across private debt sectors, we are typically seeing more attractive illiquidity premia for euro private debt sectors, with, however, higher “all-in” yields for sterling private debt sectors given the differential in sterling and euro “risk-free” rates.
We believe illiquidity premia in sectors such as living and industrials should continue to show resilience in 2024
For real estate debt, we believe illiquidity premia in thematically resilient sectors such as living and industrials should continue to show resilience in 2024. We continue to exercise caution regarding non-prime assets, particularly in the office sector.
A key risk to illiquidity premia in the short term would be worse-than-expected GDP growth or an unexpected spike in inflation. In this scenario, it is likely credit risk would sharply reprice, with private debt spreads typically lagging public markets.1
Infrastructure debt
Borrowers are accepting the “higher-for-longer" rates outlook
Infrastructure debt deal activity was stronger than some had expected in 2023. In the UK, volumes reached £28 billion, but surprisingly, it was not the most active country in Europe, with Germany closing around €32 billion worth of deals. Spain also showed a lot of activity, principally in solar energy, with 93 deals closing for €14 billion (around the same number of deals as seen in the UK).
Strong assets in the industrial and living sectors attracted debt funding at low margins, whilst weaker assets struggled to attract financing
In 2024 the focus on the energy transition and digital infrastructure is likely to persist, and while significant transport investment is expected, it will not dominate the shape of the market. However, we do anticipate an increase in the volume of activity. Infrastructure equity valuations are beginning to settle after a delayed correction following the impact of increased risk-free rates and there is greater evidence of price discovery in the market.
Borrowers are accepting the higher-for-longer outlook and are no longer hesitating to come to the market to raise more debt or refinance. Debt pricing for green assets remains very tight and offers limited illiquidity premia to relative-value investors. This is most evident in the renewables sector, where bank financing remains very active and availability of institutional debt is limited due to tight pricing. The projected continued growth in the renewable energy sector, especially UK offshore wind, will inevitably need capital and borrowers may need to bring together bank and institutional debt financing.2
Real estate debt
Continuing bifurcation between prime and non-prime assets
For much of H1 2023, there was an expectation real estate debt transaction levels and confidence would return to the market during the second half of the year. However, this did not transpire. Instead, activity in the usually busy fourth quarter remained consistent with the previous quarters. While there continues to be a focus on a refinancing gap, this has not yet resulted in a flurry of pressured refinancing or sales. As the year concluded, the growing sense of confidence that inflation had peaked led to a fairly sharp fall in rates (much of which was reversed during the early weeks of 2024).
The focus on the energy transition and digital infrastructure is likely to persist
In the UK, the pace of valuation repricing slowed during the second half of the year, which created a degree of stability. However, the bifurcation between prime and less-prime assets in various sectors (particularly offices) is still ongoing and will be a continued theme.
There was significant variation in lenders’ appetite, with some in very clear risk-off/retrenchment mode, some willing to support only existing clients and some proactively seeking to deploy. As such, there has been a mixed picture in terms of spread movements; strong assets in the industrial and living sectors attracted debt funding at low margins, whilst weaker assets struggled to attract financing other than at very high margins. Given this market environment and the wide differentiation in pricing, we believe there is scope for attractive opportunities going forward.3
Private corporate debt
Higher yields in the UK; stronger flow of deals in Europe
In private corporate debt, the UK has continued to see the majority of opportunities focused on refinancing; meanwhile, opportunistic issuances have remained severely limited due to reduced capital expenditure programmes across a number of sectors.
Private debt yields remain materially higher in the UK when compared with Europe
Private debt yields remain materially higher in the UK than in Europe, primarily driven by the differential in government debt yields; this has resulted in a stronger flow in European opportunities. Given the macroeconomic context, the risk of corporate insolvencies linked to discretionary spend is elevated and spreads have continued to widen in some sub-sectors, especially in the sub-IG market.
Structured finance
Opportunities in emerging markets
Structured finance opportunities continue to include those in emerging markets with credit guarantees from sovereigns; the guaranteed nature reduces the risk attached to the opportunity. As rates remain high and credit spreads widen for emerging market economies, the need for essential infrastructure nonetheless remains and these opportunities are thus becoming increasingly prevalent.
Note: The illiquidity premia are calculated based on Aviva Investors proprietary deal information. There are various methodologies that can be employed to calculate the illiquidity premium. Please note that illiquidity premia shown are measured against broad relevant public debt reference index data, are rating band (not notch) matched and are not duration/maturity matched.
