Public debt products are well known and widely used in investment portfolios. However, their less liquid private counterparts have emerged as a complementary source of income and diversification.
The Modern Portfolio
The construction of diversified investment portfolios has evolved continually over time but there are a few defining characteristics that have remained constant. At the core of every portfolio, positioned alongside equity investments and cash, has been an allocation to investment grade, municipal, and sovereign debt. The rationale behind this has not changed: debt investments have always played a vital role in providing a steady hand and generating income in periods of high volatility and uncertainty in equity markets. In a post-crisis marketplace characterized by central banks maintaining interest rates at historic lows, portfolio managers have been forced to look elsewhere to accomplish these goals.
While individual investors have struggled to find meaningful yield via the traditional suite of debt products, institutional investors have leveraged their larger pools of capital to explore complementary yield strategies. One such source of complementary yield which has risen to prominence in recent years is private credit.
What is Private Credit?
When private companies need to raise funds to expand their businesses’ day-to-day operations, they may not have access to the same financing options as public companies which can issue stock or bonds to the public market. Private companies borrow the money they need by obtaining loans from private lenders and in exchange make interest payments along with repaying the loan’s principle upon maturity.
As an asset class, private credit is comprised of a large variety of different debt instruments. While each has its own risk and return profile, private credit assets generally have increased risk of default, due to their typical opportunistic focus on companies with limited funding options, in comparison to their public equivalents.
After a prolonged period of time in which rates have hovered near historical lows, central banks in the US and Europe have begun to raise their benchmark rates.1 This trend is expected to continue with US Fed officials signaling the recent rate increases represented the first of an ongoing schedule of hikes.2 It is in these times of rising interest rates that portfolios containing traditional fixed income vehicles are at their most vulnerable. Private credit instruments are typically constructed with floating rate structures that can help hedge against inflation and rising interest rates. Private lenders can also deliver additional value by directly influencing pricing and structuring covenants into the terms of their loans. Private loans are typically structured as senior debt, giving the lenders payment priority in the event of a default.
Institutional investors have gravitated toward private credit over the past several years – a global survey revealed that 91% of institutional private credit investors plan to maintain or increase their allocation over the longer term.3 Institutional investors have leaned on private credit to overcome some of the many obstacles that the financial crisis of 2008 brought to the forefront. The first and perhaps most obvious obstacle is the suppressed yield from traditional fixed income. The yield available to investors on corporate, municipal, and sovereign debt has been near all time lows as interest rates have been held down artificially by central banks seeking to stimulate consumer spending activity. As a result the returns on these instruments have been greatly diminished, and in some cases negative, when adjusting for inflation. Because private credit usually involves lending to sub investment grade companies, yield on private credit assets is increased in return for taking on increased risk.
Private credit assets feature low to moderate correlation to traditional investments and the market inefficiencies associated with increased volatility present opportunities for skilled active managers to enhance risk-adjusted returns. The versatility of private debt has institutional investors utilizing the asset class more than ever, a recent survey of institutional investors found that more than a third of portfolio managers already have a distinct allocation within their portfolio.3
The Manager Matters
When considering private credit, 77% of institutional investors agreed that the most important factor in the decision making process is the track record of the manager. Top credit managers have advantages in the form enhanced deal flow as well as in pricing and covenants which can help generate additional value for investors. A growing number of leaders in credit management are beginning to recognize the demand for the asset class and bring their expertise to retail investors for the first time in the form of non-traded closed end funds, making private credit available to all modern portfolios.
As with any asset class, there are certain risks associated with private credit strategies. Credit risk is the risk of nonpayment of scheduled interest or principal payments on a debt investment. Because private credit can be debt investments in non-investment grade borrowers, the risk of default may be greater. Should a borrower fail to make a payment, or default, this may affect the overall return to the lender. Interest rate risk is another common risk associated with private credit. Interest rate changes will affect the amount of interest paid by a borrower in a floating rate loan, meaning they move in-step with broader interest rate fluctuations. However, this typically has little to no impact on the underlying value of floating rate debt. Further, private credit strategies are generally illiquid which require longer investment time horizons than other investments. For these and other reasons, this asset class is considered speculative and not suitable for everyone.
US Treasury Bond: A Treasury bond (T-Bond) is a marketable, fixed-interest U.S. government debt security with a maturity of more than 10 years. Treasury bonds make interest payments semi-annually, and the income received is only taxed at the federal level. Treasury bonds are known in the market as primarily risk-free; they are issued by the U.S. government with very little risk of default.
Municipal Bond:A municipal bond is a debt security issued by a state, municipality or county to finance its capital expenditures, including the construction of highways, bridges or schools. Municipal bonds are exempt from federal taxes and from most state and local taxes, making them especially attractive to people in high income tax brackets.
IG Corporate Bonds: Credit ratings provide a measure for comparing fixed-income securities, such as bonds, bills and notes. Most companies are issued a rating based on their financial strength, future prospects and past history. Companies that have manageable levels of debt, good earnings potential and good records paying debt obligations will have good credit ratings.
Investment grade refers to the quality of a company’s credit. In order to be considered an investment grade issue, the company must be rated at ‘BBB’ or higher by Standard and Poor’s or Moody’s.
Sovereign Debt: Also referred to as government debt, public debt, and national debt – is a central government’s debt. Sovereign debt is issued by the national government in a foreign currency in order to finance the issuing country’s growth and development. The stability of the issuing government can be provided by the country’s sovereign credit ratings which help investors weigh risks when assessing sovereign debt investments.
Sub-Investment Grade: Fixed-income instruments that carry a credit rating of BB or lower by Standard & Poor’s, or Ba or below by Moody’s Investors Service. Sub-Investment Grade bonds have higher default risk in relation to investment-grade bonds. Sub-Investment Grade bonds are risky investments, but they have speculative appeal because they offer much higher yields than bonds with higher credit ratings.
Structured Debt: Structured finance is a highly involved financial instrument offered to large financial institutions or companies that have complex financing needs that don’t match with conventional financial products. Since the mid1980s, structured finance has become a substantial space in the financial industry. These structures often use company owned assets as collateral for the loans offered by the lender.
Directly Originated Loans: Origination is the multi-step process every individual must go through when obtaining a mortgage or home loan, as well as other types of personal loans. During this process, borrowers must submit various types of financial information and documentation to a mortgage lender, including tax returns, payment history, credit card information and bank balances. Mortgage lenders use this information to determine the type of loan and the interest rate for which the borrower is eligible. Private lenders utilize these same practices to determine how they will structure loans to businesses.
To learn more about Private Credit, please contact your financial advisor.