Illiquidity premia in real assets

Read this article to understand:

• How the effects of high inflation and rising interest rates have impacted illiquidity premia across all real assets markets
• Why high demand and inflation-linkage have boosted the resilience of infrastructure debt
• The opportunities for real estate lenders in mezzanine and whole loan financings

Figure 1: Illiquidity premia in real assets (bps)

Source: Aviva Investors. Data as of February 2023

During economic downturns, illiquidity premia tend to be squeezed as private debt markets reprice at a slower rate than public market equivalents. Given the rapid increase of interest rates in response to inflationary pressures, there has been a sharp tightening in overall financial conditions over the last year.

We have started to see the impact on illiquidity premia over the last six months across all asset classes, although the extent of this depends on the sector and nature of individual transactions.

Although there has been some movement in private spreads, they have lagged public markets significantly. As for the latter, while they have narrowed since October, they remain significantly higher than 2021 levels. If public spreads remain high, we expect private market spreads to gradually widen and defaults to increase over the coming 12 months.

Nonetheless, private debt typically offers stronger covenants, protections and recovery levels relative to public debt, characteristics that assume greater value during a rising default environment.

A key takeaway from our proprietary model is that the illiquidity premium is not a static variable, but one with elements of cyclicality. This is important from an origination standpoint and can help establish a view as to where the illiquidity premia will go from here.

Changes to our methodology

For our illiquidity premia analysis, we track every deal undertaken across our real assets franchise and, from there, identify the appropriate public market benchmarks for each individual sector. This enables cross-sector illiquidity premia to be directly compared.

To better reflect current volatility, we have adapted our methodology to make our trendlines react faster to transaction-level illiquidity premia data. As this can vary widely, there is a balance to strike between overextrapolation of pricing from individual deals and taking too long to adjust. In our view, the updated trendlines better reflect the illiquidity premia available today in private markets.

We have also changed our real estate long-income methodology, basing the illiquidity premia on the forward-looking return of the CBRE Long Income index and comparing it to public corporate bonds with the same duration and credit ratings.

This index is a weighted average of three types of structures: reversionary long-lease assets, income strips and commercial ground rents. Given there are relatively few transactions in this area, this is the only proxy measure used. Other illiquidity premia are based on transactions we have been directly involved with.

Real estate debt

Although liquidity dried up significantly in the real estate debt market in the fourth quarter of 2022, it is expected that deal flow will begin to pick up early this year. Appetite remains strong for high-quality and lower-risk deals, particularly from clearing banks.

For such assets, pricing remains aggressive and has been supported by the tightening in public spreads seen since the start of the year. This has helped improve illiquidity premia for lower-risk transactions.

However, there is still a funding gap for deals impacted by rising interest rates and rapid repricing, where interest coverage ratios and loan-to-value levels are of greater concern. We see opportunities emerging as much refinancing is set to occur in 2023, particularly in mezzanine and whole loans, for which lenders demand higher margins.

In markets with strong occupational demand, such as the industrial and living sectors, investors can look through the current difficulties and remain confident in strong future rental growth. As the path to net zero continues, one of the biggest drivers of debt demand is likely to be where capital expenditure is needed to retrofit secondary offices.

Real estate long income

Real estate long income generally reacts at a slower pace to changes in interest rates than debt. The asset class provided strong relative value during the long period of low interest rates. However, with rapidly rising interest rates more recently, the illiquidity premium was initially squeezed.

Following the repricing in the second half of 2022, the illiquidity premium has begun to stabilise, albeit below its historic average. Income strips, which are priced most similarly to debt, were the quickest assets to catch up to public spreads, although illiquidity premia across all sectors have now reached a similar level.

In recent years, commercial ground rents provided an outsized illiquidity premium; as such, this part of the market experienced the least repricing, and a premium remains. Due to growing demand for matching adjustment-eligible long-income assets from insurers, it is possible there will be a future bifurcation between the illiquidity premia of such assets and those that are not matching adjustment eligible.

Infrastructure debt

Appetite among investors to lend in the infrastructure sector remains strong. Generally, it is more sheltered from macro headwinds given the essential nature of the market, coupled with the inflation-linkage many assets provide. The relative lack of supply has suppressed margins and there was only limited movement in Q4 2022.

Given strong demand and the defensiveness of the sector, we believe infrastructure debt will only experience a modest increase in margins in 2023. It is still unclear what the true impact of the increase in underlying rates will be and whether we see a knock-on effect on refinancing and M&A.

As pressure increases on banks to sell assets and deleverage in the coming months, there are likely to be more secondary market transactions. The energy transition and growth in digital infrastructure continue to drive activity as the drive towards net zero intensifies.

Structured finance and private corporate debt

At the start of 2022, private corporate debt (PCD) repriced in line with public debt spreads as the latter began to widen. During this period, value could be found over public market-equivalent bonds in low-risk and countercyclical PCD sectors such as social housing and universities.

However, towards the end of the year, primary issuance dropped significantly due to heightened macroeconomic volatility and deleveraging by pension schemes.

In structured finance, the wider market dislocation seen in the second half of 2022 has created opportunities in the asset-backed securities market. In Q4, for example, spreads on AAA-rated tranches of collateralised loan obligations (CLOs) widened to around 200 basis points, offering what we believe was an attractive entry point.

Importantly, this spread widening was driven by CLO managers’ need for liquidity given the balance sheet-light model most use; it does not reflect an increase in underlying credit risk, particularly at the AAA level. This is another example that, despite an overall squeezing on illiquidity premia, pockets of value still exist.

However, as far as CLOs are concerned, the window of opportunity is likely be short as spreads have already begun to narrow.