In our latest real assets deep dive, our research team explains how our data on illiquidity premia indicates the benefits of a multi-asset approach to private debt investing.
Read this article to understand:
- How spreads in different classes of private debt adjust at different speeds
- How illiquidity premia improved across all private debt sectors in the first half of 2024
- Drivers of activity and demand in Q2 2024
Success is in the detail, it’s often said. That thought is instructive when looking at the less-studied corners of the private debt markets.
After recent shifts in risk-free rates, the premia available on various classes of private debt have adjusted – but not uniformly.
Knowing how fast different classes tend to reprice, and carrying that understanding into relative value analysis, can guide investors seeking an analytical edge, as our latest deep dive shows.
Using illiquidity premia to assess relative value
In private debt markets, illiquidity premia (ILPs) are a key factor in assessing relative value between private sectors as well as versus public debt. For investors who can provide long-term patient capital, these premia represent the potential to harvest additional returns from investing in private debt, while 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 approach to measuring illiquidity premia
Our dataset encompasses over 2,000 private debt 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 rating 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 illiquidity premia improved across all private debt sectors in the first half of 2024. The key driver of this has been a backdrop of tightening public debt spreads (around 50 basis points over the last year) while private debt spreads have held relatively firmer.1
Tightening public credit spreads reflect market expectations that the US Federal Reserve will start cutting interest rates in the second half of 2024. The European Central Bank already made its first rate cut in June, followed by the Bank of England in August.
Figure 1: Illiquidity premia in private debt to Q2 2024
Past performance is not a reliable indicator of future returns.
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.
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 the 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.
Source: Aviva Investors and ICE BofAML index data as at 30 June 2024.
The key takeaways we draw from the data are that illiquidity premia are not static and vary through the market cycle. Secondly, illiquidity premia across the various private debt sectors do not move in tandem, reflecting different dynamics. (More details on the relative “stickiness” of private debt sector spreads versus public debt can be found in the boxed text, below.)
The vital implication is that when investing in private debt, a multi-asset approach can be beneficial and allow investors to take advantage of relative value pricing opportunities between sectors.
Infrastructure debt
Activity focused on energy and digital infrastructure
Infrastructure debt activity remained steady across Europe in Q2, with a total of around £27 billion of deals closed for the quarter; around £6 billion of that occurred in the UK.2 The UK remained the largest contributor to the European total.
Volumes were down relative to Q1; this is most likely due to a series of deals deferred from year-end 2023 into Q1 2024, which inflated the figures for the first three months. Q2 volumes are only marginally down from Q2 2023 values.
We saw a lot of infrastructure debt refinancing and general issuance activity
Activity remained spread primarily across energy, renewables and digital infrastructure. We saw a lot of refinancing and general issuance activity from regular issuers in the market, such as European rolling stock providers accessing the US private placement market, including VTG and Alpha Trains. We also saw the €1 billion Belgian road public-private partnership (PPP) project R4 close, a rare example of completed PPP deal in the market.
Real estate debt
Continuing bifurcation between prime and non-prime assets
The first half of 2024 saw a continuation of three key themes in real estate debt activity: refinancing, bifurcation of performance, and ongoing price discovery.
Transaction volumes, while low, have started to pick up
Transaction volumes, while low, have started to pick up. In aggregate, the real estate debt market has stabilised, but lenders are exhibiting appetite for the upper half of what we see as a “K-shaped” recovery, or the more resilient parts of the market, with a focus on the logistics and living sectors. Conversely, the approach remains cautious around the bottom half of the “K,” where activity remains subdued. Lenders, particularly clearing banks, have been willing to offer attractive loan-to-value (LTV) terms with LTV levels comparable to those seen before the COVID-19 pandemic.
Private corporate debt
Downward pressure on corporate spreads with the majority of new issuance focused on refinancings
We continue to see downward pressure on both corporate spreads and issuance volumes. Issuers are hesitant to lock-in heightened long-dated all-in yields and are instead opting for bank style short-dated floating rate financing structures. The majority of new issuances focussed on refinancings.
Sub-IG corporate spreads remain wide, reflecting heightened risk of default.
Structured finance
Opportunities in emerging markets
Pension deleveraging in private equity and private credit is resulting in increased credit spreads
Structured finance opportunities are being seen in defence-related export credit agency (ECA) financing because of an increase in defence spending globally. In addition, pension deleveraging in private equity and private credit is resulting in increased credit spreads and increasing appetite for matching adjustment eligible financing solutions. Fund financing as an asset class is being increasingly used by general partners (GPs) to provide much needed liquidity to limited partners (LPs) in various asset classes.
Private debt spread dynamics
- 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.
- 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 less capital available from more traditional lending sources.
- Infrastructure debt spreads tend to be moderately sticky, and re-price more gradually to public debt markets.
Figure 2: Pricing dynamics across private debt sectors
Note: ILP: Illiquidity Premium. Past performance and projections are not reliable indicators of future returns. Source: Aviva Investors, 2024.
