Did You Know? The Appeal of Private Credit
The 60/40 portfolio that relies on a 40% allocation to bonds has been an asset allocation staple for decades. The traditional credit allocation provided income and helped to balance the risk profile. With yields at a multi-decade low and inflation on the rise, investors are now looking at other sources of income. Private credit may help investors create the income they need, while maintaining a preferred risk profile.
Source: Zephyr Analytics, Cliffwater Direct Lending Index. All data is annualized over 15 years ending September 30, 2021, unless otherwise indicated. “Private Credit” is represented by the Cliffwater Direct Lending Index (from inception on September 30, 2004 – September 30, 2021). “Senior Loans” is represented by the S&P/LSTA Leveraged Loan Index. “High Yield” is represented by the Bloomberg High Yield Index. “Corporates” is represented by the Bloomberg US Corporate Bond Index. “Investment Grade Bonds” is represented by the Bloomberg US Aggregate Bond Index. “Treasuries” is represented by the Bloomberg US Treasury Index
Many private credit strategies focus on investing in middle market companies, which represent a sizeable opportunity. In the U.S., there are nearly 200,000 middle market businesses.
These businesses are often unable to access the public capital markets, and their funding needs are too small to attract large commercial banks. This has led to a rise in asset managers that specialize in lending to these companies.
As the asset class has matured, it has attracted substantial assets and four key components have emerged that underscore the potential benefits of adding private credit to a portfolio.
1. A Yield Premium
Private credit offers higher yields than other assets as these companies are not able to access other sources of funding. They also offer an illiquidity premium, as the loans are long-term investments.
2. Diversification
Low correlation with traditional credit asset classes can improve portfolio diversification. Private credit has historically had a low correction to investment investment grade bonds and have been negatively correlated to U.S. Treasuries.
3. Interest Rate Risk
Loans made to private companies typically have floating rates, meaning their interest rates adjust as market interest rates rise or fall.
4. Stability in Difficult Markets
Private credit strategies demonstrated resiliency throughout the pandemic. This may be the result of the two features of these types of loans. They are typically senior secured loans that are at the top of a company’s capital stack, and have recourse to the company’s assets in the event of default. The lender also has the ability to specific covenants on the loan that give the lender a degree of control.
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.
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Any strategy discussed does not guarantee against investment losses.
