PE-backed bonds: innovating for income

INCOME from lower-risk investments is a highly prized attribute, but it is elusive. As at mid-December an estimated US$18 trillion of government debt is negative yielding globally, of which investment grade debt's share is 27 per cent.

As central banks' monetary and fiscal policies around the world are expected to remain accommodative to cushion the economic shock wrought by Covid-19, investors particularly pre-retirees and retirees are forced to consider higher-risk investments.

One Singapore institution, Azalea Asset Management of the Temasek group, has sought to enable access to private equity investments for the retail public - in the form of coupon-bearing bonds.

The firm has an ongoing programme of issuance of PE-backed bonds. While there was no issuance in 2020, it is reasonable to expect that the pipeline will soon be reactivated.

One may wonder, why tap PE as an underlying exposure? Scores of unit trusts pool together dividend equities, corporate and government bonds. They are also designed to generate income and have done so for decades.

PE investments historically have generated returns far above traditional markets.

This potential for higher returns enables a manager to create a cushion for a structure that pays a fixed coupon every six months. The cash flows from the underlying PE funds are used to pay off the bonds, interest and other expenses.

Traditional PE funds do not typically pay a regular income. There is also a long lock-up period of eight or 10 years. And the minimum ticket for entry may be as much as US$1 million. Investors must also qualify as institutions or accredited investors.

Azalea's innovation is that it pools together a portfolio of over 30 PE funds into asset-backed securities under its Astrea platform.

Each portfolio comprises varying vintages, managers and sectors. Since around 2006, there have been five Astrea issuances; the first two were open only to institutions. Astrea III in 2016 was open to accredited investors.

Only Astrea IV and V, launched in 2018 and 2019 respectively, were open to retail investors. The bonds are listed on the SGX which provides a liquidity avenue not typically available in direct PE investments.

Only the lowest risk tranche A-1 was available for retail subscription.

First a quick recap of how the retail issuances have fared. Astrea IV has held steady over the past few months.

Even at the market trough in March 24, it fell to a low of 99 cents before clawing back at the close to $1.001. Its last price at Feb 19 was S$1.057. Astrea V fell to a low of 95 cents on March 24 and closed at 98 cents. It closed at S$1.04 on Feb 19.

Here are some things you should note, should you consider investing.

Interest rate environment

The rate outlook, macro conditions and quality of issuance are among factors considered by institutions in the book-building process for each launch. The same rate that emerges from the process is used for the retail tranche.

So far the trend among Astrea launches appear to indicate a declining trend in coupon or interest rates at launch.

For Astrea IV (launched 2018), Class A-1 notes had a coupon rate of 4.35 per cent; 5.5 per cent for A-2 and 6.75 per cent for Class B notes.

Astrea V's rates (launched 2019) were 3.85 per cent for Class A-1 notes; 4.5 per cent for A-2 and 5.75 per cent for B.

Even if the underlying assets are PE funds, investors should not expect returns comparable to a direct PE investment, which may be in double digits, as a long lock-up period commands a liquidity premium.

Product highlight sheets for Astrea's retail tranche make it clear that the issue is for those who seek regular income rather than capital growth.

And, like most other bonds, there is a chance that the bonds could default. There are safeguards against this. But more on that later.

Covid-19 impact

The Astrea annual report FY19/20 gives insights into the impact of the pandemic up to end of March 2020.

PE-backed exit activity moderated in 2019 but remained at levels higher than the 2014-18 five-year average, "as GPs (general partners) capitalised on elevated valuations to monetise their investments''.

Citing Bain data, the report said 2019 was the ninth consecutive year in which distributions outpaced capital calls.

But historical data suggests that PE exits fall sharply in periods of market uncertainty, because asset valuations are in flux and growth trajectories are in question.

On Astrea in particular, the report said GPs may hold back divestments, which may in turn lead to Astrea funds receiving less distributions.

"Many businesses have experienced a drop in revenues and profitability as a result of the Covid-19 outbreak. These may in turn impact cash flows and asset valuations, resulting in valuation losses as experienced across the Astrea portfolios in the last distribution period.''

Specifically, the loan-to-value (LTV) ratios of Astrea III and Astrea IV exceeded their maximum LTV ratios on their respective July and June distribution dates.

For Astrea III, Class B notes were partially redeemed which reduced the LTV from 35 to 25 per cent, which is the LTV cap.

In the case of Astrea IV, cash was diverted into the Class A reserve account. The LTV remains below the maximum level of 50 per cent.

The sponsors of Astrea IV and Astrea V have also deemed it prudent to de-risk the structures, "even though these Astrea transactions received sufficient cash to service their bond obligations for the respective distribution periods ending in June 2020''.

The sponsors have directed the manager to direct cash, which was due to them under the priority of payments, into the reserve accounts.

This reduces the net debt positions of Astrea IV and Astrea V. This is one of the structural safeguards to ensure the integrity of the issue.

The report said Fitch Ratings reviewed Astrea ratings in April 2020 amid the Covid-19 backdrop. It affirmed the ratings for all outstanding Astrea PE bonds, and upgraded the rating of Astrea III Class B notes.

"According to Fitch, all three Astrea portfolios have performed well and significantly better than the stress scenarios run in its initial rating analyses. In their view, the ratings point to Astrea PE bonds' ability to withstand stresses in the portfolio.''

Structural safeguards

The Astrea issuances feature a number of safeguards. Each portfolio is diversified across 30 to 40 funds in the buyout and growth strategies, which helps to mitigate the risk of any single fund. Azalea has picked more mature funds which are likely to make distributions sooner than later.

Each issue is typically over-collateralised. The structure also has committed bank facilities to pay for operating expenses and interest to bondholders, as well as a capital call facility. In Astrea IV and V, the manager also has the flexibility to retain cash as a buffer against cash flow needs.

Class A bonds have a scheduled call date of five years, but all bond classes have longer maturities of 10 years, which gives additional time to weather a downturn, as Fitch points out.

If Class A-1 bonds are not redeemed in full on their scheduled call date, a one-time 1 per cent per annum step-up interest rate will apply.