Asia Pacific asset owners seek more alternative credit in fixed income diversification, finds Nuveen survey

The past two years of rising interest rates and accompanying market volatility have been a clear reminder to investors of the need to diversify portfolios. Even though the outlook for inflation, rates and economic growth has settled, Nuveen’s 2024 institutional investor study finds that 40% of Asia Pacific investors are looking to increase allocations to private fixed income.

The survey also reveals that nearly seven out of 10 investors are going above and beyond regulatory requirements on energy transition. Insurers, in particular, are looking at infrastructure across the capital stack to achieve a variety of goals from income and diversification to managing the decarbonisation agenda.

Amid this trend, private infrastructure tied with private credit is the top pick for insurers which plan to increase alternative allocations.

The challenge for these and other asset owners will be in identifying investments which offer the right balance of upside return and downside risk. Selectivity – coupled with a broad perspective on the full alternative credit opportunity set – will be key.

Playing to their advantage, a higher rates environment is an attractive prospect for entering the alternative credit space, particularly within direct lending. Meanwhile, the continued push towards a low-carbon economy is another driving factor for energy and infrastructure credit.

Direct lending

The opportunity in senior lending remains compelling, with the vintages of 2022, 2023 and likely 2024 being attractive.

Senior debt all-in yields, underpinned by the floating rate component of loans, have been boosted by the rise in rates to around 12%. At the same time, structurally lower leverage, tighter covenants and more cash equity going into leveraged buyouts (LBOs), add to the existing benefits of floating-rate lending, offering a natural rates/inflation hedge, stable valuations and illiquidity premiums.

From an issuer’s perspective, direct lending holds a strong position in the market and remains the preferred financing option for new LBOs over public credit by a wide margin (Figure 1).

Figure 1: Non-bank lenders continue to take market share from global banks (%)

_{Data source: PitchBook LCD, Given the lack of primary issuance, LCD did not track enough observations to compile a meaningful sample for 2009, 2020, 2022 and YTD 2023. Note this refers to loans issued by banks and held by for term, i.e., not the syndicated loan market}

Direct lending in Europe offers investors the ability to capitalise on a private debt market benefiting from improved risk-adjusted returns similar to the US, spurred by increased deal volumes, improved pricing, lower leverage and high-quality borrowers.

At times of severe volatility and dislocation, discounted debt purchases and liquidity/refinancing solutions may become more compelling. In contrast, when the market is fully priced, specialist lending may be more effective. Yet 2023 saw unique market conditions where all strands of the capital solutions opportunity set were simultaneously attractive.

While some businesses with pricing power, manageable leverage and hedged interest rate exposure continue to perform, other companies are grappling with an array of challenges accumulating over the last few phases of the cycle.

The retrenchment of traditional lenders has left a significant supply gap that private debt investors are able to fill with flexible capital.

In Europe, a strong driver of the demand for credit is the more than €100 billion ($109 billion) wall of debt maturities coming due in the next two years. The market has digested approximately €30 billion of institutional loan extensions in 2023 through August, including with the support of flexible capital providers. The market’s maturity profile continues to be upward sloping. At the same time, significant risk of supply/demand imbalance continues, presenting an opportunity for special situations investors.

Energy and infrastructure credit

Energy infrastructure investment should remain appealing for asset owners given several megatrends that are stoking demand for capital.

The biggest of these is the push to decarbonise. The capital required to achieve this for the global economy is tremendous, with electrification playing a significant role. In the US, for example, the Department of Energy estimates that existing domestic grid capacity will need to increase by 57% by 2035 to support the increased demand. This will, in turn, generate investment opportunities in areas such as onshoring the US supply chain for clean energy sources and increasing production capacity of minerals critical to these efforts.

The most significant driver of this megatrend is the US Inflation Reduction Act, which will prove an effective tailwind for energy investment opportunities focused on electrification, onshoring of the supply chain and manufacturing of storage.

Additionally, Canada and the EU have created companion incentive programmes which are catalysing a robust global investment opportunity set. This has all occurred as bank lending standards have continued to tighten, while periodic bouts of volatility in capital markets create opportunities for non-bank lenders.

Decarbonisation opportunities are also inevitably complex and capital intensive, with large-scale projects requiring highly experienced oversight to successfully manage them.

Inflation is also an important factor, manifesting in the form of increased staffing costs due to shortages of specialised labour and higher supply chain costs. These projects face higher costs of capital because they may fall outside the bounds of conventional project financing due to possible merchant exposure or development risk. However, these opportunities often possess hard asset collateral underpinned by contracted offtake agreements and robust cash flows. An experienced lender can capitalise on these attributes to structure deals which mitigate the attendant risks.

More broadly, decarbonisation in Europe is a critical topic, requiring significant investments from local governments and the private sector. Supported by EU initiatives such as REpowerEU, the EU aims to be less dependent on fossil fuels by accelerating the energy transition toward more sustainable and clean sources of energy.

To achieve its net zero targets, non-bank lenders like Nuveen are needed to directly provide financing to energy transition projects or support bank financing through structured finance solutions.

Digging deeper

As an increasing number of investors look to fold alternative credit into portfolios, understanding the different factors at play in each sector becomes more important.

For 2024, and beyond, attractive risk-adjusted returns in this opportunity set will come from being selective, navigating project and business complexities, and structuring investments with sufficient downside protections.

For a breakdown of the wider macro environment and how it affects different alternative credit sectors, read Nuveen’s 2024 Alternative Credit Insights.

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