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When corporate defined benefit (DB) plans see their funded status improve, their focus turns to derisking steps, including the use of what we call liability-hedging diversifiers — asset classes and strategies outside of traditional public investment-grade credit and government bonds. Figure 1 shows our framework for evaluating different liability-hedging diversifiers, which we discuss in detail in a recent paper. In this article, we focus on the fifth column: private investment-grade (IG) credit, or private placements. In particular, we consider:
Figure 1
While the direct lending market tends to garner a lot of the headlines, the private credit space includes a broad array of asset types, as shown in Figure 2. Private placements are less familiar to some but have been around for decades and typically attract strategic buy-and-hold investors looking to lock in returns and cash flows to support their liabilities. Unlike much of the private credit universe, including direct lending, private placements are primarily considered investment grade and are generally issued as fixed rate debt. In addition, they are available at a wide range of tenors, making them customizable as a potential complement to an LDI strategy focused on public IG credit.
Figure 2
While the private placements market is much smaller than the public fixed income market, it is similar in size to the direct lending market. It sees about US$100 billion in issuance a year — roughly broken down to about US$80 billion of bank-agented syndicated issuance and US$10 billion – US$20 billion of non-syndicated direct origination. Unlike the public market, where any investor can see a deal and place an order, the private placements market is relationship driven. Investors need to be invited to participate deal by deal, just as they do in the direct lending market. In contrast to direct lending, however, there are just a handful of players in the private placements market who can originate non-syndicated deals.
We are often asked about the liquidity of the private placements market, and certainly it can be viewed as less liquid than the public fixed income market given that it’s a private asset class driven largely by buy-and-hold investors. That said, the negotiated-relationship nature of the market generally means that demand materially outweighs supply and potential buyers are willing to engage in discussions. As a result, the market typically does not experience the type of wholesale liquidity-driven market dislocation we sometimes see in public arenas. There is also a private placements secondary trading market, with about US$2 billion – US$4 billion in trading annually, which can help when building portfolios. However, it would be challenging to rely entirely on the secondary market to buy securities, with most players looking to hold these assets to match their liabilities.
Figure 3 offers a number of other details on private placements and how they compare to the public market and the direct lending market.
Figure 3
We see three key reasons that investors, including DB plan sponsors, may want to consider an allocation to private placements:
Incremental yield — Investors may be able to earn a premium over a comparable public market investment, driven by the deal complexity and reduced liquidity, while maintaining a similar credit quality. This premium can differ greatly deal by deal, but it has historically tended to be at least 50 basis points (bps) for syndicated deals. More recently, it has increased to about 72 bps in 2024, as higher all-in public IG yields have provided more competition from yield-based investors. We would note that this spread premium may be even higher for managers with the ability to be selective in the syndicated market and participate in differentiated origination sources.
Diversification — Private placement issuers include not only corporates, utilities, and financial issuers, but also non-corporates such as sports teams, higher education institutions, health care organizations, and municipal or sovereign credit exposures. The universe also includes contract monetizations and project financings (e.g., a manufacturing facility or energy plant, or an infrastructure-related project like a solar farm or airport). As a result, private placements can offer different exposures versus public investments and potentially less issuer concentration. They can also offer geographic diversification, since about half of annual private placements issuance comes from outside the US, and a wide range of maturities from 3 to 30 years, as well as some non-standard maturities.
Downside mitigation — The credit-protective covenants and prepayment provisions offered by private placements may play a role in mitigating downside risk. These credit-protective covenants include make-whole premiums that are required if bonds are optionally prepaid in a lower-interest-rate environment; in addition to making longer durations available, this may enable investors to match their liability tenor needs and better lock in a known return. These structural protections may provide investors with a seat at the table if there’s a material change in the issuer during the investment, and give them the ability to renegotiate, reprice, or even force prepayment of the bonds depending on the situation. These benefits may support private placements’ stature as a long-term core asset for LDI-driven investors now that these investments are becoming more broadly available.
For corporate plans using a AA corporate discount rate, credit migration, or what we call “downgrade drag,” has historically resulted in a roughly 50 bp annualized headwind between a duration-matched hedging portfolio and the liability. This is because downgraded bonds are typically negative for index returns but have no bearing on the liability. Assuming a 75 to 100 bp illiquidity premium, a 10% private IG allocation could offset 7.5 to 10 bps of this headwind with a nominal effect on funded-ratio volatility, given that the allocation remains in IG credit (while the long-term average for the market is closer to 50 bps, we think managers with the necessary capabilities and experience may be able to target a higher range, as noted earlier). Alternatively, many plans look to equities to make up for the downgrade drag, but that increases funded-ratio risk. But private IG credit — because it is, in effect, an extension of the public market — has a relatively neutral effect on projected funded-ratio volatility. From that standpoint, we’d argue that private placements could be a potentially low-risk way to chip away at an uninvestable liability headwind.
We’d also add that a typical liability profile — even for a more mature, frozen plan — is expected to pay out upwards of 40% of its liability more than 10 years out from now. This can make plans a natural liquidity provider, a position they may want to take advantage of.
The current market opportunity
We think the environment may be attractive for investing in private placements and aiming to protect funded-ratio gains, with yields at levels the market hasn't seen in some time. As noted, the average spread pickup in the syndicated market so far in 2024 is about 72 bps. In addition to potentially locking in higher yields, it may also be a chance to enhance derisking efforts with the incremental downside protection that's found in private placements, as well as the diversification they may offer.
Manager selection
We think the choice of manager can be critical in this negotiated asset class. We encourage investors to dig into potential managers’ underwriting and deal structuring capabilities, especially with respect to experience through cycles. In addition, investors should evaluate managers’ ability to originate deals while also maintaining access to the syndicated market. We also think that a differentiated outcome really rests on a manager's ability to deliver on the specific investment needs of a client. This makes it critical to explore any potential competing areas of focus for a manager, as well as to give close consideration to their client relationship servicing and reporting capabilities in this differentiated asset class.
Allocation sizing
In general, we think a private placements allocation of 10% – 20% of liability-hedging assets may be appropriate. Plans may need at least 10% to reap the benefits of private placements, and those with more flexibility on liquidity, such as those with longer liability durations, could potentially be at the higher end of the range.
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