A Guide to Investment Grade Private Credit (2024)

Private placements are debt offerings issued by a corporate borrower and are similar to public bonds. In both asset classes, companies pay a fixed rate of interest over a set period of time.

However, privates may achieve additional yield and total return compared to corporate public bonds of similar credit quality and duration due to higher up-front yields, prepayment and amendment/waiver fees, and lower actual credit losses in the event of default. Historically, investment-grade private placements have offered a spread premium to similarly-rated public corporate bonds.

Spread

The interest rate on a private placement is expressed as a nominal spread over a base rate, namely, the comparable maturity U.S. Treasury. Borrowers choose a wide variety of maturities, including five, seven, ten, 12, 15 and 30 years. Borrowers sometimes will also offer unique maturities (e.g., 22 years or amortizing schedules) depending on their borrowing needs.

The nominal spread is the amount of interest that a borrower will pay in addition to the base rate. This spread is typically a fixed amount, and it is expressed in basis points. The spread differs across industries depending on the creditworthiness of the particular borrower.

To understand the interest rate locked in by a borrower on a private placement, if the ten-year U.S. Treasury was currently at 1.50%, a borrower whose spread was 200bp above the ten-year rate would pay interest at a rate of 3.50%. The spread is higher than a similarly-rated public bond due to an illiquidity premium. Top-tier investors such as Voya generally achieve a higher average spread to publics than the overall market (Exhibit 1).

We measure our spreads via reference to a basket of individual public bonds of equivalent term, credit rating, and sector, as we consider this more accurate. It also reflects the matrix pricing methodology most commonly used to price new investment grade private placements. However, this method tends to slightly subdue yield spreads compared to the simpler option of calculating them against an index. For example, over the past five years, Voya averaged a 92 bp spread over equivalent public bonds, but it inflates to 110 bp when measured against the Bloomberg Barclays U.S. Corporate Bond Index.¹⁴

Tenor

Issuers in the private placement market typically issue notes with maturities between three and thirty years; the most common maturities are seven, ten and twelve years. Historically, the attainable spread to public bonds is higher in the shorter tranches due to 1) demand for longer-duration product from many investors and 2) the lower absolute level of interest rates. Private investors have held to minimum yield hurdles more stringently than their public counterparts.

Contractual protections

Private placements are made under the terms of a written contract—the note purchase agreement—which sets the interest rate to be paid by the borrower. It also sets limitations on a borrower’s business operations designed to enhance the probability that the lenders will be repaid. Such limitations, called covenants, are designed to monitor the financial health of a borrower and limit the ability of the borrower to incur additional debt.

If the borrower violates these restrictions, the note purchase agreement gives lenders an option to take certain actions against the borrower, ranging from increasing the interest rate on the note to calling the notes and requiring the immediate repayment in full.

Covenants

Covenants are unique to each transaction, can vary widely depending on circ*mstances and are virtually nonexistent among investment grade public bonds. The covenants are designed to maintain pari passu (or equal) treatment with other senior creditors, and to force prepayment while the credit is still financeable by its banks or other lenders. When an exit is not possible, terms can be renegotiated to improve recovery rates if payment default ultimately occurs, or to increase the yield via fees and coupon rate increases.

Generally, there are three types of covenants:

1. Those that protect the note holder’s position in the capital structure

2. Those that protect against credit deterioration, and

3. Those that protect against “event risk,” such as the company favoring equity holders overcreditors.

Private placements are callable at any time; however, the call is at a “make-whole” price. While technically complex, the make-whole concept allows the investor to maintain the initial yield of the investment over the remaining term, regardless of whether interest rates have increased or decreased since funding. Hence, while privates are fully callable, they are not negativelyconvex.

We estimate the long-term excess value of covenants to be approximately 36 bp versus non-covenanted public bonds. Value comes from amendment and waiver fees,pre-payment fees, and coupon increases (25 bp) and lower losses in the event of default (11 bp).

Prepayment

The standard provision in the U.S. private placement market is that notes are callable at the greater of the “make-whole” premium or par. The make-whole premium is calculated as the value of the notes being prepaid discounted at a rate equal to the sum of (a) the current rate of the U.S. Treasury with the same average life as the notes and (b) 50 bp. This formulation protects the note holders during times of declining interest rates.

In theory, the note holder can take the returned principal, interest and make-whole premium and invest it in a security with the same average life as the prepaid notes, yielding U.S. Treasuries plus 50 bp and remain “whole” with respect to the original yield on the investment. In rising interest rate conditions, note holders can “sell” the notes at par, which still provides a premium, because the bond is worth less in the higher interest rate environment, and then reinvest at higher yields. Private placement notes are callable at any time, but because of the make-whole provision they are not negatively convex. Make-whole fees as a percentage of the total portfolio will vary, because companies may choose to prepay loans on an ad hoc basis.

Recoveries

The private credit asset class has an inherent advantage over public bonds due to its negotiated covenant structures that are tailored to each credit. Private placements generally are pari passu with bank loans and ahead of unsecured bondholders. As a result, if a company becomes distressed and falls into bankruptcy, private placements are in line to be repaid with the banks and typically get paid back before public bondholders, preferred shareholders or holders of a company’s equity. This has led to significantly higher recoveries on defaulted private placements in comparison to recoveries on defaulted public bonds. From 2003 to 2022 at Voya, private placements demonstrated a recovery rate of about 91% compared to unsecured public bonds, which have historically recovered approximately 46% (see Exhibit3). This compares to industry average recovery rates of 63.4% for investment-grade private credit as a whole, according to a 2019 Society of Actuaries study.¹⁵