Investment Strategy

Weekly market insights and possible impacts on investors from the Wells Fargo Investment Institute Global Investment Strategy team.

Equities | Fixed Income | Real Assets

June 17, 2019

Justin Lenarcic, Global Alternative Investment Strategist

The Not-So-Secret World of Private Credit

Key Takeaways

  • Private credit strategies may seem secretive and complex, but they share many similarities with public credit (e.g, corporate or securitized bond markets). The key difference is the type of borrowers to which private credit investors typically lend—and the structure of those loans.
  • While a large amount of capital has been allocated to private credit strategies, especially those focused on direct lending, we expect an abundance of potential opportunities to exist as the U.S. credit cycle matures.

What it May Mean for Investors

  • For qualified investors, private credit strategies historically have generated a higher yield and return—with lower defaults—than public (corporate) credit has.1

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A simple definition of private credit can be hard to find, and even harder to understand. Terms like capital relief, rescue financing, or even direct lending can be both intuitive and ambiguous. They can confuse investors who perceive this asset class as secretive and overly complex. But the truth is that private credit strategies are quite similar to their public credit counterparts—where the common foundation is simply the act of lending and receiving interest (and principal) in return.2 There are several differences, but the world of private credit isn’t nearly as secretive as it may appear to be, in our view.

Defining private credit

Perhaps the best way to define private credit is to start with what it isn’t. Public credit is generally defined as either corporate or securitized credit. Corporate credit includes investment-grade (IG) and high-yield (HY) debt securities, along with emerging market debt. Leveraged loans—or bank loans—fall within the corporate credit sector.

Securitized credit focuses on debt backed by assets such as residential and commercial real estate, student and auto loans, credit cards, and collateralized loan obligations (CLOs).3 Mutual fund and exchange-traded fund (ETF) investors can invest in securitized credit, but the focus often is on IG debt, for which liquidity typically is sufficient. Truly capturing the illiquidity premium offered within securitized credit requires a longer-term investment horizon.

What makes private credit private?

The banking sector has seen steady consolidation for decades—more recently accelerated by increased regulation following the financial crisis. This has led to an increase in nonbank lending, and it formed the foundation of the private credit market. Because the ultimate holders of public credit are removed from the origination process, they have little control over the structure of the bond or other financing vehicle, or over the pricing.

Chart 1. Declining number of U.S. commercial banksChart 1. Declining number of U.S. commercial banksSources: Federal Deposit Insurance Corporation, Bloomberg, June 2019.

Private credit is different in that it is a much more “hands on” approach. Covenants and deal structure are actively negotiated between borrower and lender, giving private credit investors much more control over the loan, which ultimately (and hopefully) results in greater control over risk and performance. Within securitized markets, private credit investors can parse through pools of loans, selecting only those to which they want exposure.

Common private credit strategies

Private credit tends to be a catch-all category for a variety of strategies, but below are a few of the more common sub-strategies.

  • Direct (corporate) lending: Smaller, middle market companies have turned to private credit investors to secure bridge financing or capital for other bespoke opportunities.
  • Direct (residential) lending: In some instances, legacy (pre-crisis) mortgages that may be delinquent or need modification can be purchased and cured. Other strategies involve purchasing mortgage servicing rights (MSRs) from banks to assist with Dodd-Frank regulations.
  • Specialty finance: Also known as trade finance, this strategy normally involves purchasing a pool of insured receivables from a small business or large corporation that needs the capital before the receivables are delivered.
  • Regulatory capital relief: Brought about by the financial crisis and the regulatory overhaul of banks, regulatory capital relief transfers credit-loss risk from financial institutions’ balance sheets to private investors.
  • Rescue finance: Occasionally, good companies have unexpected liquidity shortfalls or temporary operational problems. These companies may not qualify for bank loans and may need an alternative source of financing.

Benefits of being “private” late in the credit cycle

With yields on traditional fixed-income securities near historic lows, many investors are looking for ways to enhance their income. Compared to traditional public (e.g., corporate) credit, private credit historically has generated a higher yield and return, with lower defaults.4 Furthermore, private credit often has floating-rate coupons, making it a potentially attractive hedge to increases in interest rates.5

As Chart 2 shows, the amount of capital raised for private credit remains high, even considering a pullback in 2018. While certain strategies, such as direct lending, have seen a significant increase in dry powder, there are multiple avenues for private credit investors to take. We anticipate that rescue financing and other forms of distressed and special situations strategies could be well positioned as the credit and business cycles mature.

Chart 2. Private credit assets are near historical highsChart 2. Private credit assets are near historical highsSources: Preqin, PIMCO, December 2018.

We expect public credit market risks (particularly in HY corporate markets) to increase going forward. Within the alternative investment space, such an environment can lead to greater opportunities for private credit investors. As lending conditions tighten, alternative forms of financing will become more important. While the growth of the private credit sector bears consideration, we believe that diligent, private credit investors that methodically allocate capital will have no shortage of opportunities.

Equities

Ken Johnson, CFA, Investment Strategy Analyst
Audrey Kaplan, Head of Global Equity Strategy

As trade uncertainty fuels markets—what may lie ahead?

Trade headlines (and the Federal Reserve) recently have driven equity markets. The S&P 500 Index fell by -2.4% on a single day last month (on a price-return basis) as a U.S.-China trade agreement became less certain. In early June, Federal Reserve members hinted at a rate cut, and the S&P 500 Index rose by 2.1% in a single day. Fear of the unknown, reinforced by news headlines, can fuel significant volatility. The chart below shows U.S. trade-policy uncertainty since 1998 (using a sub-index of the U.S. Economic Policy Uncertainty Index).

During months in which this index spiked above 150 (reflected in the dotted line), the S&P 500 Index moved by as much as 880 basis points from one day to the next. (One hundred basis points equal 1.00%.) Despite this volatility, the S&P 500 Index had risen 78% of the time 6 months later; had gained 67% of the time 12 months later; and was up 67% of the time 18 months later (on a total-return basis). Of course, past performance is no guarantee of future results.

If the U.S and China were unable to reach a trade agreement, it clearly could have negative consequences for fundamentals and the global economy. Yet, that is not our base case. We expect these two nations to eventually reach a trade agreement. The trade tensions are negatively impacting near-term earnings, but we expect them to recover next year. We remain neutral on U.S. Large Cap Equities—and we believe that this is an appropriate time to review portfolio allocations and align them with targets.

Key takeaways

  • Trade policy uncertainty is at a record high (as the index below has averaged 210 since 2017)—a 281% increase from its average of 55 between 1998 and 2016.
  • The U.S.-China trade dispute has created earnings-growth headwinds, but we expect low interest rates and modest growth to support most global equity valuations near recent levels.
Trade policy uncertainty has risen over the past three yearsTrade policy uncertainty has risen over the past three yearsSources: Wells Fargo Investment Institute, Baker, Bloom, and Davis, Bloomberg, June 12, 2019. Shaded areas represent a recession. Chart shows the U.S. Categorical Economic Trade Policy Uncertainty Index, which is a sub-index of the U.S. Economic Policy Uncertainty Index developed by Baker, Bloom, and Davis. An index is unmanaged and not available for direct investment. Please see end of report for the index definitions.

Fixed Income

Peter Wilson, Global Fixed Income Strategist

Developed market view—eurozone policy rate expectations turn lower

Ten-year German bund yields have now moved to historical lows below the 2016 level of -0.20%. There are three main reasons for the decline in this key eurozone rate. The first is the global growth slowdown, with Germany’s manufacturing and export-oriented economy being particularly impacted by slowing trade and tariff threats. Second, European political and financial risks—from populists in Italy and Brexit in the U.K.—have driven core yields lower on a flight-to-safety response.

A third related factor is that investors now expect further European Central Bank (ECB) easing. The chart below looks at market policy rate expectations at six-month intervals from January 2018 to present. It shows that, during the eurozone growth slowdown in the second half of last year, the investor response was to push back forecasts of eventual ECB rate increases. What is different this year is that the market now anticipates ECB rate cuts.

At its June 6 meeting, the ECB extended its forward guidance—stating it now “expects the key ECB interest rates to remain at their present levels at least through the first half of 2020.” At the press conference, outgoing ECB President Mario Draghi clarified that some ECB members were considering the need to cut rates further or restart bond purchases. German bund yields may remain at these ultra-low levels until current trade disputes are resolved and clearer signs of a eurozone manufacturing recovery are seen. This reinforces our unfavorable developed market (DM) debt view.

Key takeaways

  • Historically low German bund yields are being driven by the growth slowdown—along with Italian and Brexit risks—but also by expectations of further ECB rate cuts.
  • Whether these expectations are fulfilled or not, eurozone yields likely will remain at very low, or negative, levels for some time. We remain unfavorable on DM debt.
Market expectations for ECB policy rates turned lower this yearMarket expectations for ECB policy rates turned lower this yearSources: Bloomberg, Wells Fargo Investment Institute, June 10, 2019. EONIA is the Euro Overnight Index Average rate. These forward-looking policy rate expectations are derived from the Overnight Index Swaps (OIS) market. An overnight index swap is an interest-rate swap that involves the overnight rate being exchanged for a fixed interest rate.

Real Assets

John LaForge, Head of Real Asset Strategy

China fears spark gold

“Better to light a candle than to curse the darkness.”
--Chinese proverb

In the June 10, Investment Strategy report article titled, “Gold as a Perceived Safe Haven,” we wrote about gold’s prospects in 2019. Our bottom line was that gold looks expensive at $1,340. It also does not offer a good risk/reward trade-off, with roughly $60 of potential upside (to $1,400), and $140 of possible downside (to $1,200). For serious long-term buyers, we say wait for much lower prices, probably sub-$1,200.

Where gold goes in the very near term, though, is anyone’s guess. It wouldn’t shock us to see gold make a quick run at $1,400 first, before it starts heading lower, toward $1,200. Gold’s short-term fate likely will be decided by the timing of a U.S.-China trade deal. Should news of a deal drag on over time, we suspect that gold prices could continue to leak higher. After all, it was the May news that the Chinese were backing away from the trade table that sparked the drop in the Chinese yuan (orange line in the chart below), and the rallies in alternative currencies, such as gold (yellow line) and bitcoin (grey line).

To be clear, we do not recommend buying gold today based upon U.S.-China trade deal fear. We believe that a trade deal between the U.S. and China will get done—and that once the trade fear fades, so will gold. Bitcoin is shown in the chart for perspective purposes only, to highlight that gold can sometimes move with alternative currencies. Alternative currencies are currencies that are not officially printed by governments, represented in this chart by bitcoin. For investors in countries such as China, which restrict official currency leaving the country, alternative currencies and gold can be utilized as hedging strategies.

Key Takeaways

  • Gold may make a quick run at $1,400 should news of a U.S.-China trade deal drag on.
  • We do not recommend buying gold based upon trade deal fear—as we expect a deal to eventually get done—and, with it, fear and gold to both fade.
Bitcoin, gold and the yuanBitcoin, gold and the yuanSources: Bloomberg, Wells Fargo Investment Institute. Daily data: January 2, 2018 - June 12, 2019. Gold and yuan are indexed to 100 as of May 31, 2018. Yuan movements are shown inverse. Past performance is no guarantee of future results. Please see the end of the report for important risks and definitions.

Alternative Investments

Justin Lenaric, Global Alternative Investment Strategist

Searching for yield (again)—and the impact on credit dispersion

Over the past 8 months, the percentage of negative-yielding global fixed income assets has surged (from 12% in October 2018 to 21% on May 31, 2019). Declining yields resulted from a reduction in economic-growth forecasts and a benign inflation outlook—which is being addressed by central bankers taking a more dovish monetary policy stance.

With such a large percentage of global fixed-income assets providing negative yields, it is possible that we will again see investors “search for yield” as they seek to maintain required income levels. By doing so, these investors will have to take on more credit risk, which could increase demand for lower-rated bonds and leveraged loans. Ultimately, this could flatten the corporate-credit yield curve—particularly in the high-yield (HY) space—and reduce credit dispersion.

One of our core views has been that the maturing credit cycle would pose opportunities for Long/Short Credit funds. A greater level of dispersion between strong and weak balance sheets should allow talented managers to build both long and short credit positions. The search for yield could challenge that thesis if investors are willing to overlook deteriorating fundamentals.

One way to gauge credit dispersion is by the distribution in HY bond prices. In a “search for yield” environment, 30-50% of HY bonds can trade above a price of $105. Fortunately for Long/Short Credit managers, the current percentage of developed market HY bonds trading above $105 is only 11%.6 Should we see a significant increase in this percentage, we likely would reconsider our view on this strategy.

Key Takeaways

  • The percentage of negative yielding global fixed-income assets has nearly doubled since the fourth quarter.
  • If investors return to a “search for yield” mentality, we may see a negative impact on credit dispersion that could alter our views on Long/Short Credit strategies.
A surging percentage of global fixed-income assets with negative yieldsA surging percentage of global fixed-income assets with negative yieldsSource: ICE Data Indices LLC, June 2019. Global fixed income is represented by the ICE BofAML Global Fixed Income Markets Index. The chart is showing the proportion of that index that has negative yielding bonds. An index is unmanaged and not available for direct investment. Please see the end of the report for the definition of the index.

 Alternative investments, such as hedge funds, private equity, private debt and private real estate funds are not suitable for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws.

1 BCA Research, “Private Debt: An Investment Primer”, June 2018.

2 Barring an unforeseen event, such as default.

3 A collateralized loan obligation (CLO) is a security consisting of a pool of loans that are organized by maturity and risk.

4 BCA Research, “Private Debt: An Investment Primer”, June 2018.

5 Ibid.

6 Source: ICE Data Services, LLC. June 2019.

Risk Considerations

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing.

Long/short credit strategies seek to mitigate interest rate and credit risks regardless of market environment through investment in credit-related and structured debt vehicles. These strategies involve the use of market hedges and involve risks associated with the use of derivatives, fixed income, foreign investment, currency, hedging, leverage, liquidity, short sales, loss of principal and other material risks.

Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.

Bitcoin Risks

Buying, selling and using Bitcoins carry numerous risks. Digital currency such as Bitcoin is not legal tender. No law requires companies or individuals to accept Bitcoins as a form of payment. Instead, Bitcoin use is limited to businesses and individuals that are willing to accept Bitcoins. If no one accepts bitcoins, bitcoins will become worthless.

Platforms that buy and sell bitcoins can be hacked, and some have failed. In addition, like the platforms themselves, digital wallets can be hacked. As a result, consumers can and have lost money.

Bitcoin transactions can be subject to fraud and theft. For example, a fraudster could pose as a Bitcoin exchange, Bitcoin intermediary or trader in an effort to lure you to send money, which is then stolen.

Unlike U.S. banks and credit unions that provide certain guarantees of safety to depositors, there are no such safeguards provided to digital wallets.

Bitcoin payments are irreversible. Once a transaction is completed, it cannot be reversed. Purchases can be refunded, but depend solely on the willingness of the establishment to do so.

Bitcoin has been used in illegal activity, including drug dealing, money laundering and other forms of illegal commerce. Abuses could impact consumers and speculators; for instance, law enforcement agencies could shut down or restrict the use of platforms and exchanges, limiting or shutting off the ability to use or trade bitcoins.

Definitions

ICE BofAML Global Fixed Income Markets Index tracks the performance of developed and emerging market investment grade and sub-investment grade debt publicly issued in the major domestic and eurobond markets, including sovereign, quasi-government, corporate, securitized and collateralized securities. It combines the flagship Merrill Lynch Global Large Cap (investment grade), Global High Yield and Global Emerging Markets Sovereign & Credit Indices.

U.S. Categorical Economic Trade Policy Uncertainty Index includes a range of sub-indexes based solely on news data. These are derived using results from the Access World News database of over 2,000 U.S. newspapers. Each sub-index requires economic, uncertainty, and policy terms as well as a set of categorical policy terms.

U.S. Economic Policy Uncertainty Index (Baker, Bloom, and Davis): To measure policy-related economic uncertainty, this index was constructed from three underlying components. One quantifies newspaper coverage of policy-related economic uncertainty. A second reflects the number of federal tax code provisions set to expire in future years. The third uses disagreement among economic forecasters as a proxy for uncertainty.

An index is unmanaged and not available for direct investment.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

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