The Third Lever of Yield
Individual retail investors have historically had to accept that generating increased yield from their fixed income portfolios is accompanied by accepting greater risk – whether through decreasing credit quality or increasing term.
Bonds below investment grade typically offer a higher yield premium than investment-grade bonds to compensate for a higher risk of default. Similarly, long-maturity bonds typically offer a higher yield premium than short-maturity bonds. This is to compensate for interest rate risk due to the investor holding the bond over a longer time period.
But there is a third lever that fixed income investors can pull: liquidity. In other words, investors that accept lower liquidity can potentially earn higher yields.
An Alternative Lever: Illiquid Private Credit
Illiquid private credit can offer more attractive yields than public credit due to an opportunistic focus on companies with limited funding options. In addition, if markets turn downward, loan funding may become scarce and some private lenders can often charge a premium for access to capital.
Directly originated senior loans have generated an average 500 bps premium over traded loans since 2017.
Source: Cliffwater Direct Lending Index. Morningstar LSTA US Leveraged Loan. *Data as of 9/30/2023.
These loans typically comprise senior secured notes, which are at the top of the capital structure and can be backed with recourse to company assets, offering risk mitigation. The historical recovery rate for these types of securities from 1987 – 2023 is approximately 70%, according to a study by S&P Global Ratings.
Portfolio Utility: Lower Correlation to Public Investments
While investing in private credit can offer more attractive yield, it may also provide further portfolio utility – especially during the late stage of the business cycle. Because loans are not traded on public exchanges, they tend to have a lower correlation to public debt and equity instruments. This makes them a potential source of portfolio diversification.
One of the fastest-growing sub-asset classes within diversified private credit is direct lending – bilateral agreements between one borrower and one lender. Direct lending typically focuses on middle market credits, which may be considered by investors because they can offer diversity across both geographies and industry sectors. The middle markets have also shown resilience, and outperformed during 2007–2010, the depth of the GFC, by adding 2.2 million jobs.1 In 2023, revenues increased for 83% of middle market companies at an average rate of 12.4%, representing two new high marks for the middle market. Middle market companies of all sizes and across nearly all industry segments reported strong growth with most of the growers growing at a rate of 10% or more.2
The chart below shows the correlations between middle market loans and public equity and bond market indices.
Source: Bloomberg. Asset classes are represented by the following indices: U.S. Equities, S&P 500; Investment Grade Bonds, Bloomberg U.S. Aggregate Index; High Yield Bonds, Bloomberg US Corporate High Yield Index; Middle Market Loans, Cliffwater Direct Lending Index.
Investing in Private Credit: The Manager Matters
Experienced managers in the direct lending space have a vigorous approach when it comes to their investing process. Most managers often spend three to six months in due diligence on a company. This helps them to understand the ins and outs of the particular business including the balance sheet, talent, collateral, growth plans and risk.
Once managers make an investment, they have a tendency to hold the loans long term which allows them to be a part of the strategy over several business cycles. Most managers tend to invest in senior loans, which can offer more risk mitigation as they sit at or near the top of the capital structure.
Direct lending requires intensive, bottom-up fundamental research and thorough due diligence. Manager success in this asset class can depend on access to capital, experience, and expertise across all stages of the business cycle. In addition, if markets turn downward, volatility increases, and loan funding becomes scarce, larger investors can likely charge an even higher premium for access to capital.
How Can Retail Investors Get Access?
Because most private credit strategies involve long-term investing in assets that are not traded on exchanges, they are considered to be illiquid. This lack of liquidity is the third lever of yield. An innovative structure, the interval fund, makes this lever available to individual retail investors, as long as the investor can accept only periodic liquidity. An interval fund is a type of closed-end fund that continuously offers new shares for sale but buys back existing shares only during specified periods, or intervals.
Risks
As with any asset class, there are certain risks associated with private credit. 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. Further, private credit investments 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 appropriate for all investors.
An interval fund has risks that include lack of daily liquidity and can expose investors to liquidity risk. Each fund will also have specific capital, market and strategy risks, depending on the underlying fund assets which can be affected by economic downturns, interest rate changes, credit quality, and other factors that can reduce their value and performance. They can also have higher fees than traditional mutual funds, which can erode their returns and reduce net asset value (NAV) of the fund and the amount of money available for repurchase. Therefore, interval funds are best suited for investors who have a long-term horizon, a high-risk tolerance, and a diversified portfolio. These risks are outlined in the prospectus and should be read carefully.
To learn more, please contact your financial professional.
