Private credit could present a “hidden risk” for investors | Intraday

As many credit assets are illiquid, that is, poorly traded in the secondary market, the value that appears in portfolios may be very different from the price that will be obtained by trying to sell the asset on the market.

When the universe of credit assets is updated to reflect market conditions, the value equates on average to 95% of the nominal price of the securities, according to estimates by POP BR, the illiquid asset pricing company of Luz Soluções Financeiras. At first glance, the difference may seem minimal. However, precisely because it is an average, it ends up masking larger deviations, which occur precisely in more leveraged and less liquid companies.

“Even though, on average, mark-to-market presents a loss of around 5%, specific cases that present problems can lead to significant losses. Furthermore, if we consider the growing volume of trading, the number of people affected further amplifies the importance of mark-to-market,” says Aruã Torigoe, analyst at POP.

There are traditionally two ways to indicate the value of a bond asset at any given time. “Curve marking” is the method of valuing a security using the interest rate contracted when the paper was issued, causing the value of the security to grow in a predictable and consistent manner. It is a way of estimating how much the investor will have if they hold the asset until maturity. If a credit event does not occur – a default or a legal recovery request for example – the allocator will receive the contracted amount.

However, if you need or want to dispose of the asset before the deadline, the investor will be subject to market conditions. When an asset is mark-to-market or MTM, information such as market risk – such as the fluctuation of the benchmark interest rate since the time of issuance – and the credit risk of that issuer, in addition to other variables, is incorporated into the price.

An example of this dynamic is evident when tracking the secondary market price of CRAs from input distributor Belagrícola. In October, the company suspended payments to its creditors for 60 days after a favorable court ruling. According to a survey by consultancy Uqbar, the shares were illiquid and even after that, price fluctuations in the secondary market were insignificant.

The problem is that the investor who tries to get rid of the paper will hardly receive an amount close to that contracted at the time of issuing the security. At the beginning of December, at the request of Valuea manager contacted banks and distributors to obtain a current quote for the newspaper. On the only fixed income trading platform where active offers were found in the secondary market, there were only purchase proposals (“offers”) for one of the 18 CRAs issued by Belagrícola and accompanied by the report. However, even on this platform, the market was almost non-existent. While the purchase price was 4% of the stock’s total value (“par”), the sale price (“ask”) was 63% of the stock’s value – a very significant distance that signals no activity.

Similar episodes are noticed by a wide range of market professionals involved in resource management. João Henrique da Fonseca, economist and founding partner of Azul Wealth Management, reveals that when trying to get rid of some CRI that a new client had in his portfolio, he did not succeed even when offering a 60% discount on the securities.

“Fortunately, we have very few assets of this type, most of them inherited from previous family management. But if we try to get rid of them, we cannot. Even if the markers say that the markup is 99% of par, there is no demand at this price. If there is demand, it is 30% of the value. These asymmetries worry me in the Brazilian market,” he says.

He notes that the problem is becoming more and more common and that the difficulty of tagging assets ends up reinforcing unfavorable behavior. “For some time now, I’ve started to notice an asymmetry in what’s actually happening in corporate credit and in the prices of corporate assets. “Those who understand credit are starting to fear the fact that there are companies with very poor balance sheets, with leverage of 5 or 10 times EBITDA and news of delays in the newspapers, but with the price of assets marked by distributors at par. This simply does not correspond to reality.”

Fonseca thus underlines the possibility of a vicious circle of incentives. “As illiquid products are branded in a more innocuous way than the real thing, investors wrongly believe that they are safer and more profitable products and tend to prefer these assets. As a result, distributors perceive greater demand and end up creating more illiquid products. There has been an explosion of stipulated real estate funds (which are not traded on an exchange and have low liquidity). A vicious cycle of self-deception is created. The investor tends to do not manage the truth well and the market chooses to create an offer of illiquid products and services to meet this demand,” he explains.

Journey Capital partner Rogê Rosolini also reports that he faces this situation with some frequency. Although the Anbima regulations have required financial institutions to mark-to-market securities since January 2023, certain regulatory loopholes have allowed investors to restrict their own options for accessing the price closest to the current asset price.

“The strength of the lobby allowed the qualified investor to mark the curve. What did we see next? A strong commercial movement to convince clients to leave their mark on the curve. And there is also the other widespread practice of turning a blind eye to those who declare themselves qualified even without meeting the requirements,” he says.

According to him, the possibility of tracing the curve is like a patient breaking a thermometer so as not to see that he has a fever. “If credit quality deteriorates, the ‘yield’ (yield) will increase and that is an indicator that things are not going well. But there are a range of reasons why the industry seeks to avoid this wherever possible. Imagine a bond with an average maturity of 10 years and which trades with a spread of 0.5% per year between the buying price and the selling price. This would have a 5% impact on the price. The client invests and, the next day, it would see the asset 5% below the invested value. So there is great strength to avoid valuing everything to market, but it is in the best interest of the client,” he says.

Regarding CRIs and CRAs, Alfredo Marrucho, content director at Uqbar, says there is a distortion caused by tax incentives. “Individual investors are one of the main investors in the CRI and CRA market. It goes without saying that most do not have the knowledge or time necessary to analyze these securities. On the other hand, large companies see the vehicle as a way to finance themselves at a lower cost. In practice, we have concentrated/corporate medium-term securitization securities in the hands of individual investors,” he says.

The scenario, according to him, is made worse by a precarious data culture. “The information regime required by the regulator is basic and participants are reluctant to voluntarily make granular support data available. If the performance of the support is not known, pricing is greatly hampered. Even when there is a CRI real estate investment trust on the investment side, managers do not always demonstrate the maturity necessary to value a CRI and end up doing something very close to the curve value. A high profile institutional investor should not depend solely on the secondary to value a CRI.

Another problem is the difficulty of trading lower values ​​on the secondary market. “Who is going to spend time analyzing a security without granular data and buying R$500,000? An institutional security will not be. And in addition: how does the individual investor who sells know if the asking price is well-founded? It seems clear to me that this asymmetry generates a distortion in the formation of prices”, he declares.

Rafael Paschoarelli, professor of finance at the University of São Paulo (USP), believes that the debate is complex. “Sometimes there is no magic. If the asset is not liquid, how are you going to give the market price? The second aspect is that in the statement the institution has to put a price and there is no market price. You could create a model and it would be a price using mathematical methods, which would estimate the price based on other similar securities. The other possibility is to put it on the curve that the client bought. But it is not a price, it’s a theoretical exercise, a fiction. There is no easy solution,” he said. said.

“The problem is that when you have a market price, it is unfavorable to the client and the asset remains marked on the purchase curve. Then there is a very serious problem. There is a misalignment, or a conflict of interest.”

The difficulty is also extrapolated to the world of investment funds. It is the responsibility of administrators to update portfolio asset prices and use models to value securities with low liquidity. For Guilherme Cooke, partner at Lobo de Rizzo Advogados, attribution is a complex task.

“This is an obligation assigned to the administrator, a party who charges 0.1% per annum. This is an extremely difficult debate. Today the role of marking is in the hands of someone who does not have access to information and, when we look at an illiquid and uncertain asset, we are essentially talking about a ‘valuation’ service, which is a knowledge closer to that of the manager. The responsibility for determining ‘fair value’ is disproportionately assigned “It creates a strong relationship between the administrator and the manager to value the asset, which increases the risk of conflict of interest. Even more so for these assets which are more complicated.”

On the one hand, the mark on the curve carries the risk of wealth transfer among an open-end fund’s shareholders, according to Cooke. On the other hand, maturity is insufficient on the secondary credit market. “What the rule says is not bad, but it is difficult to do. What ultimately is necessary is liquidity risk management.”