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Text on screen: What is behind the changing banking landscape?
Images on screen: Christian Stracke, Jason R. Steiner and Kris Kraus presenting at the alts conference
Christian Stracke: What's changing is really the retrenchment of banks.
And it has reignited the attention of regulators to what's going on at banks.
Text on screen: Christian Stracke, PIMCO President and Global Head of Credit Research
Higher rates drove people to reassess why do they have deposits at a bank earning far less than they could earn on bills or on other fixed-income products and began to withdraw those deposits out of banks.
That's what's accelerating the expansion of the opportunity set this year with the entire system really reassessing how will credit be provided in the economy. Who will intermediate the extension of credit in the economy? It's really that fundamental question. And so that's kind of how we think about the private credit opportunity is it's not a product. It's not a financial product in which investors can invest. And ultimately it is, of course, but it's really a response to this fundamental change in the dynamics of how credit is intermediated in the system as banks face the reality that their business model is structurally challenged.
Text on screen: What are the risks in corporate lending amid changing banking landscape?
Images on screen: Christian Stracke, Jason R. Steiner and Kris Kraus presenting at the alts conference
Christian Stracke: We'd flag a couple of different things. First of all, Lincoln International, which is an important valuation, third-party valuation agent for private credit direct lending loans, put out a report in the summer saying that of the loans that they assess, almost half will have less than one times fixed-charge coverage ratio if rates remain above 5 percent.
Fixed-charge coverage ratio is EBITDA minus capex divided by interest. So interest costs have risen so much that almost half of the loans that they're looking at, and they look at a very significant percentage of the loans in direct lending funds, will be burning cash and will be burning cash for some time if the Fed remains higher for longer, as now seems to be the case. This is not a portfolio that is not seeing erosion of fundamental credit quality. It very clearly is seeing a very serious erosion of one of the most important credit KPIs, which is interest coverage.
Now, the other thing that kind of dovetails with that is the system needs lending into arrears because interest rates are so high. It is preposterous to claim that there's not serious erosion in the floating rate leverage finance market right now, whether it's in private credit direct lending or for that matter, in the bank loan space.
Text on screen: What are the potential areas of growth and investment in the lending market?
Images on screen: Christian Stracke, Jason R. Steiner and Kris Kraus presenting at the alts conference
Kristofer Kraus: We think that overall the consumer's in pretty good shape.
Text on screen: Kristofer Kraus, Portfolio Manager, Alternative Credit
So in using the data and the analytics that we've been investing in for many years now, we feel gives us a real edge to pinpoint where we want to participate in these markets.
We're finding some really interesting opportunities in those spaces in addition to what we're also doing in some of the non-consumer areas.
Jason Steiner: We talk quite a bit about the strength and the fundamentals in the housing market.
Text on screen: Jason R. Steiner, Portfolio Manager, Alternative Credit
Today's mortgage loans that are potentially available for sale from larger banks are the best credit borrowers out there, very low loan-to-value ratios.
Fundamentals look very good in that part of the market and it's a compelling opportunity on the debt side. On the mortgage side, the stickiness of the reregulation of the mortgage industry continues to be another kind of tailwind for strong mortgage performance.
One of the best opportunities that we've seen over the last couple of years has been intermediating the public and private markets. So available to us at a time when public market valuations are very tight and you can originate and own private debt, private mortgages, private mortgage loans and securitize them and have a very attractive locked in yield at a low cost of funds. Obviously the cost of funds are higher now.
We still think that investing in mortgage credit is still attractive today. And we think that doing securitizations, issuing deals, sponsoring the securitizations, is one way in the mortgage markets to actually stay long options.
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Text on screen: PIMCO
DISCLOSURE
https://www.lincolninternational.com/perspectives/articles/leading-indicators-show-risk-for-potential-loan-payment-defaults-in-the-next-twelve-months/
Earnings before interest, taxes, depreciation and amortization (EBITDA); US Federal Reserve (The Fed)
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed.
Alternative investments involve a high degree of risk and can be illiquid due to restrictions on transfer and lack of a secondary trading market. They can be highly leveraged, speculative and volatile, and an investor could lose all or a substantial amount of an investment. Alternative investments may lack transparency as to share price, valuation and portfolio holdings. Complex tax structures often result in delayed tax reporting. Compared to mutual funds, private funds are subject to less regulation and often charge higher fees. Alternative investment managers typically exercise broad investment discretion and may apply similar strategies across multiple investment vehicles, resulting in less diversification. Trading may occur outside the United States which may pose greater risks than trading on U.S. exchanges and in U.S. markets. Private credit involves an investment in non-publically traded securities which are subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Investments in Private Credit may also be subject to real estate-related risks, which include new regulatory or legislative developments, the attractiveness and location of properties, the financial condition of tenants, potential liability under environmental and other laws, as well as natural disasters and other factors beyond a manager’s control. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income.
Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower’s obligation, or that such collateral could be liquidated. Diversification does not ensure against loss.
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