Investment opportunities in alternative credit are expanding. At the same time, private market allocations for insurance companies are growing as a way to enhance income, diversify investments, and seek to meet return goals. At PIMCO’s recent Financial Institutions Group (FIG) Summit in New York, Devin Chen, head of real estate strategy, Mary Anne Guediguian, account manager in the financial institutions group, Lalantika Medema, alternative credit strategist, and Jamie Weinstein, head of corporate special situations, discussed PIMCO’s outlook for alternative credit and how to position for opportunities.
Q: “Private credit” and “alternative credit” are broad terms that can mean different things to different investors. How does PIMCO define and think about these areas?
Medema: Historically, private credit has been associated with direct lending in corporate credit markets. We think of alternative credit as applying to all lending that occurs outside of the public markets. Non-bank providers of capital have taken on a greater role in the lending markets after the financial crisis in 2008−2009, and private lending has evolved significantly. Insurance companies have also become growing participants in this market, mostly in higher-quality corporate private placements and commercial mortgage loans.
PIMCO’s focus tends to be on more opportunistic parts of the market, which we refer to as alternative credit. In the context of real estate markets, this can range from newly originated residential non-qualified mortgages to lending on transitional commercial real estate assets. In the corporate and special situations sectors, this ranges from lending to companies undergoing idiosyncratic or secular changes to aviation finance and consumer or specialty lending.
Today, PIMCO currently manages over $20 billion in alternative credit and private strategies that invest in public and private markets. These include opportunistic vintage vehicles, opportunistic evergreen and hybrid structures, and private lending mandates. We invest across four main pillars: residential real estate, commercial real estate, corporate credit, and specialty finance. PIMCO’s platform arose from the financial crisis and has grown organically over the last decade. We began to step out of the structured credit market just before 2007, and after the crisis began, we came back in as a liquidity provider. That aligned with our core competencies – strengths that remain today – helping us to be flexible and access opportunities across both public and private markets.
Q: How can insurance companies benefit from this approach?
Guediguian: We think there are areas of the private credit market that can offer diversification from the primary risk exposures found within insurance portfolios. For example, residential credit is an area that can offer attractive yields and risk profiles. Parts of commercial real estate lending, specialty finance, and special situations corporate lending also can offer attractive returns with a risk profile that is different from typical insurance holdings in private placements or commercial mortgage loans.
In looking at the U.S. insurance industry’s allocation to alternatives (as reported on the insurance statutory schedule BA) over the past decade, although traditional hedge fund assets have declined, all other alternative investments have seen increased allocations ($110 billion in 2008 and a 2.9% portfolio allocation vs. $179 billion in 2018 and a 3.5% portfolio allocation).1 We think this trend will continue, and believe it is important to take a relative value orientation to credit across sectors, capital structure, and liquidity. The benefit of this approach, rather than a more siloed sector focus, is that it allows us to seek the most attractive opportunities on a risk-adjusted basis. For example, in today’s low risk-premium environment, PIMCO’s focus on senior credits that have a significant component of their return profiles tied to income and that we believe to be resilient may fit in well for an insurance company portfolio.
Similarly, in preparing for a possible market dislocation, we are focused on two types of structures for clients to invest: drawdown structures with a multi-year investment window that deploy capital over time; and contingent capital structures, in which capital has been raised and is ready to access when a market event or catalyst occurs. Insurers that can afford to give up liquidity in exchange for yield and diversification potential may be able to benefit from these structures. As the alternative credit universe has expanded, PIMCO’s strategies not only aim to access opportunities in today’s markets but also position for opportunities that may arise in a future market dislocation.
Q: Commercial real estate has long been a staple allocation in many insurance company portfolios (particularly life insurers). How would you characterize the current state of the U.S. commercial real estate market?
Chen: It’s a very interesting environment right now. Overall, we think conditions are pretty benign. If you look at the fundamentals, on one hand we see positive rent growth across most sectors other than retail, but on the other hand, supply is picking up across the board and rent growth is decelerating. And that’s likely to continue given where we are in the economic cycle. However, we don’t see severe dislocations, other than some pockets like New York City high-end residential and the Houston office market. The market is relatively in balance.
In terms of the capital markets, the lending market has been healthy, with relatively good liquidity in most areas, and that’s been a tailwind for commercial real estate. Transaction volumes continue to be strong as well, with year-to-date volumes flat compared to last year and still near record highs. However, cross-border investor activity has declined sharply. Foreign investors are now net sellers of U.S. commercial real estate after six consecutive years of growth. Chinese investors, in particular, have reduced their U.S. acquisitions due to domestic capital constraints.
Interest rates have declined significantly over the past year, but cap rates have not declined much during that time. There’s been tremendous volatility with rates, and until that subsides, cap rates likely won’t compress much. Going forward, with slowing fundamentals and relatively flat cap rates, we expect modest price appreciation for the sector overall – low-single-digit type of growth in 2020. We are positioning our portfolios to be even more resilient and favor sectors that we think will outperform in a recessionary environment due to demographics and consumer trends. For example, we like student housing as a sector because of captive demand and the secular trend toward education attainment. This is one of the few sectors that experienced rent growth even during the financial crisis. We also favor industrial real estate assets that are attractive to e-commerce tenants who are willing to pay significantly higher rents to get closer to their consumers near population centers.
Q: What unique opportunities is PIMCO seeing within the U.S. commercial real estate market today?
Chen: Given our outlook on the market, we are actively looking at investment opportunities in the senior part of the capital structure where we can find compelling risk-adjusted returns. We’ve been focused on the 10%–15% portion of the debt market for lending opportunities that don’t fall neatly to one of the traditional lending sources, namely banks, insurance companies, commercial mortgage-backed securities, or the agencies. We find there is pricing power in this part of the market on a relative basis. These loans are typically collateralized by transitional properties that don’t generate stable cash flows or aren’t located in a core market, or may involve borrowers that require higher loan-to-value ratios than the traditional funding sources can advance. Despite these considerations, if the sponsorship is strong, their business plan is sound, we are comfortable with our last dollar basis, and we are able to structure the loan appropriately to mitigate risk, we are comfortable being a liquidity provider for this type of credit. We continue to see attractive opportunities to deploy capital in this area, particularly during times of market volatility.
Q: Within the corporate sector, how does PIMCO view middle-market lending, and where do you see opportunities in corporate lending overall?
Weinstein: There’s no question that middle-market corporate lending, especially for sponsor-backed businesses, is significantly overcapitalized. As a result, covenants overall have become weaker: Investors can theoretically check the box that an offering has covenants, but realistically, they may never be triggered.
After the financial crisis, much middle-market lending activity moved out of banks and into private credit funds. Moving the risk off of bank balance sheets may be better systemically, and these funds are generally less leveraged depending on the investment sponsor, but that doesn’t mean that the credit risk is better.
So where is the opportunity? From time to time, we see very challenging, “storied” situations − opportunities that may be recapitalization or rescue-finance situations. Also, very recently, we are starting to see banks shifting their risk away from providing financing against pools of private loans, which signals to us that banks have concerns about the underlying credits.
It doesn’t take outright distress for there to be an attractive set of investments available in the corporate sector today. It takes volatility or idiosyncratic events that create opportunity. For example, many investors pulled back from the IPO market earlier this year, leaving several companies in need of capital. This was not a broad market dislocation but rather a micro event that created potential opportunities for investors.
Q: What opportunities does PIMCO see today in the residential mortgage market?
Medema: As a result of the financial crisis, the mortgage market has undergone significant changes, opening up a number of areas for less liquid or private capital to step in. The opportunity set includes public securitized assets, legacy performing loans, re-performing loans, new loan origination, and mortgage servicing rights. One area PIMCO has been quite active in is investing in U.S. non-qualified mortgages, which are loans that are not sold into government agency mortgage-backed securities.
These types of loans typically include near-prime FICO (credit) scores and higher down payments. This type of lending is growing, due in large part to regulatory mandated tight credit standards. By our estimate, in 2015 about $1 billion in nonqualified mortgages were made, and in 2019, more than $20 billion will be made.
In our view, performance has been very strong, which we believe is driven by better underwriting coupled with equity alignment with the borrower. While credit risk exists and is ultimately dependent upon the strength of the U.S. consumer, in recent years we have seen delinquencies under 2% and losses of less than ½ basis point per annum. In our view, pools of non-qualified mortgages tend to offer stable cash flows that can be enhanced through various forms of financing to create the potential for resilient return profiles in the low double-digits.
Q: What are some of the challenges in alternative credit and how can investors navigate them given where we are in the credit cycle?
Weinstein: In the corporate market, without strong covenants, the early warning system for lenders that might enable them to prevent further deterioration in a structure is gone. That means that losses from defaults will likely be much higher in the next downturn, especially in below-investment-grade credits. Historically, recoveries for secured bank loans were about 70%–80%, but we think secured recoveries in the next credit cycle will look more like those on high yield bonds, which are typically closer to 40%−50%. That could be an exciting opportunity for many investors with fresh capital, but a big challenge for investors with exposure today.
Chen: It’s been a different story in commercial real estate lending. Lenders have maintained discipline for the most part, both from a leverage standpoint and structure standpoint. Most loans still carry strong covenant packages, particularly those on transitional assets. There are some pockets where we have seen structure loosen, such as lending on limited service hotel portfolios, but overall the market is still behaving rationally.
One area we focus on is valuation. Specifically, we are seeing some instances of what we view as overly optimistic appraisals on loan collateral that don’t reflect the true value of the underlying asset. This can lead to excess leverage. To mitigate this risk, we do our own underwriting and valuation work instead of relying on third-party appraisers. We’re able to do that because we invest and asset manage similar types of transitional CRE assets through our equity business, and our team utilizes the same investment process when analyzing loan collateral. This is critical to our lending process, particularly at this point in the credit cycle.
Q: How might insurance companies think about taking advantage of these opportunities?
Guediguian: We think a flexible and opportunistic approach to investing can offer several advantages to insurance companies as they seek to enhance yield and diversification in a prudent, risk-adjusted manner. It is important to understand current exposures across both public and private investments, and seek new investments in private credit that will help diversify risk, with reasonable liquidity give-up and consideration given to other factors such as risk-based capital. We think insurers can think holistically about their balance sheet and identify opportunities in private markets that do more than simply offer illiquidity premiums. We believe that by applying a broader lens and considering investments outside traditional private assets, insurers can find unique ways to address income and total return goals.