By Erik Sherman

Debt investments, particularly in real asset categories such as infrastructure and commercial real estate, have become popular with pension funds.

However, moves by central banks are starting to push key interest rates down, raising the question of what will happen with interest rates overall and whether pension funds and other institutional investors will need to reconsider their strategies.

Popularity of Real Asset Credit

Private credit, especially in real assets, has become popular in investment. The returns on debt can be strong, offering higher levels of return.

“We believe that investing in real asset debt can potentially help enhance fixed income portfolios,” Brookfield noted in March 2023. “We find real asset debt can offer potential investment benefits over broad debt thanks to the unique characteristics of real asset businesses.”

British Columbia Investment Management Corporation (BCI) manages CAD$16.1 billion invested in private debt. At the end of 2023, Ontario Municipal Employees Retirement System (OMERS) held CAD$11.5 billion in fair-value private debt and mortgages. The College Pension Plan included 6% private debt in its CAD$7.15 billion of investment holdings in 2023. The Ontario Teachers’ Pension Plan held CAD$38.6 billion in credit investments in 2023, 43% of which were levered loans, 40% in high-yield, 5% in investment grade, and 12% in emerging market sovereign.

As OTPP noted in its 2023 annual report, “Credit is a component of a company’s capital structure that contains characteristics of both equities and fixed income. Investing in credit allows Ontario Teachers’ to capture default, liquidity and funding risk premiums.”

A focus on credit for real assets also adds some risk management as there is something of tangible value backing the loan, unlike, say, lending to a so-called zombie company.

Volatility Enters

However, things have changed in debt over the last two years. As post-pandemic inflation — set off by supply chain failures and too much liquidity pumped into the hands of investors looking for — rose, central banks stiffened interest rates to slow economies. Owners of infrastructure and real estate who might have taken short-term interest-only loans with balloon payments found that increased interest rates made refinancing initial loans made at low rates and high leverage difficult to obtain. Simultaneously, many banks increased underwriting requirements and heavily cut back on the loans they were granting.

Debt programs and funds could often provide financing when owners had few other options. The rates were relatively high. Underwriting could consider the nature of the real asset and its operational cash flow, determining if there were ways for borrowers to manage repayments.

And then, in the last six weeks, new volatility considerations came into play. Inflation was down and central banks in a non-centralized way started changing rates. The Bank of Japan raised rates, sending the carry trade — borrowing in low-rate currencies and investing in higher-rate ones — into short-term panic. The Bank of England lowered rates by a quarter point a day later. Then the European Central Bank cut its rates by a quarter point on September 12.

And then, finally, the Federal Reserve Bank cut by 50 basis points. But things didn’t all move the same way. Important short-term rates dropped by September 24, like the secure overnight financing rate (SOFR) falling from 5.38% to 4.83%, the 1-month Treasury yield tumbling from 4.91% to 4.78%, and the 2-year from 3.61% to 3.49%. But the 10-year rose from 3.65% to 3.74%.

Where does that leave lending in general and private debt on real assets in particular? The rate changes aren’t enough to save some properties that were in trouble, and even if they were, it would take time for their effects to percolate through the economy.

“There are going to be and have been a number of buildings financed in the last decade that aren’t worth the debt that’s been lent against them,” says John Nicolini, a managing director and senior consultant at Verus. There have already been significant failures. Even some major real asset investors have turned keys back to lenders on some of their properties.

Rate cuts are so small as to be currently ineffective, banks as the lower-rate lenders are still reluctant. But conditions continue to change. According to forward curves based on straight market activity, SOFR will continue downward through 2025 until they bottom out at about 2.8% in early 2026. The 10-year Treasury will fall to about 3.6% by mid-2025.

That assumes markets are good at prediction, which they often aren’t. If they were, rate cuts would have started in March. As Carol Ng, managing director of hedge advisory firm Derivative Logic, told GlobeSt.com, “I think we’ll have a lot of outlier events that will come out of the woodwork [and affect rates]. We have all these big things that are happening.” But no one knows when they will happen or what effect they might have.

If rates do drop, debt may no longer look as attractive to investors. “If you’re an institutional investor who writes to a net 8-point return and all of a sudden it’s 7 or 6-and-a-half, it probably doesn’t make sense to put more money in,” Nicolini says. “You’re going to have to explain why, relative to everything else you can do, this is one of the best things you can do. If spreads don’t move out, then why am I going to keep putting money into an asset class with 100, 150 basis points lower when the risk hasn’t changed?”