5 min read 12 Jun 23
Multiple shocks to economic stability over the last three years have forced the world to think on its feet as various crises – including the Covid-19 pandemic, Russia’s ongoing war in Ukraine and the run-on banks – unfolded in real time. Meanwhile, dramatic fiscal and macro-prudential policy changes have been implemented while asset valuations have continued to fluctuate amid ongoing uncertainty.
Investors with long-term objectives have emerged from a period of lower-for-longer yields and years of rock-bottom interest rates with a fresh set of unique challenges including high inflation, rising interest rates and generally volatile investment conditions.
One bright spot in the recent volatile record is funding ratios for pension schemes have improved as rising interest rates have helped to erode liabilities. Many defined benefit schemes, for example, are either close to or fully funded. However, if there’s one lesson that has been reiterated in multiplicity over the last decade, it’s that market conditions can change rapidly and without warning. Finding assets that can reliably deliver a steady stream of income in challenging and uncertain environments is crucial to maintaining the recent funding gains, but where could schemes look to invest in order to meet their long-term objectives, and how do asset owners rationalise this with shorter term dynamics whilst minimising volatility?
Private credit can offer flexible exposure to alternative and differentiated types of income-bearing assets in various fund structures including open end funds, which can help investors on their quest to meet their long-term goals via diversified cash flows. There is a broad range of options within the private credit universe, ranging from private corporate lending to consumer finance, real assets lending and structured credit which have very different underlying risks and performance drivers. This provides opportunities for investors seeking a secure income stream at different stages of the cycle. However, it is still important to consider what areas are adequately developed, provide diversification to an asset owners unique risk factors, and can generate a healthy yield pick-up relative to public market assets.
Whilst many long-term investors were faced with the challenge of lower yields for longer only a year ago, it is clear consensus has shifted away from a return to zero base rates, and the new challenge is generation of sustainable real income. We believe private credit provides a viable solution to both long term and near term needs with a level of “insurance” embedded via a two-way duration neutrality. On the upside real income is preserved from rising rates due to the floating rate nature of the underlying assets with a strong historic positive correlation with inflation. On the downside the income stream is protected by the presence of zero-minimum, rate-fixing floors, providing a source of extra value in the face of low or even negative rates, ensuring nominal income is not eroded by negative rates.
Currently traditional credit classes such as Investment Grade Corporates and Government Bonds struggle to generate real income returns over long term inflation levels (c.2%), much less versus the current high single digit levels. Whereas within private credit, most asset classes typically provide real income in the long term but also in the short term elevated inflationary environment.
Investors don’t necessarily need to reach for the riskiest segments to achieve this, they can maintain liquidity via Leveraged loans which are daily tradeable on par with public credit; or maintain Investment Grade/Cross Over credit risk via Infrastructure Debt and ABS which are able to meet these objectives ahead of lower rated public High Yield for example.
Beyond providing a potentially attractive source of risk-adjusted returns at a premium to liquid counterparts, private credit also offers lower correlation to other asset classes and in turn lower mark-to-market volatility, particularly in downturns where correlations tend to increase. The returns are not contingent on short-term macroeconomic dynamics nor price returns, most private assets are held to maturity and benefit from long term allocated capital from the investor base. It is not subjected to the volatile sentiment and retail driven flows of more public markets; flows tend to be driven largely by credit fundamentals.
In 2022, private credit demonstrated this durability maintaining its track record of outperforming public markets. Returns were generally in positive territory – ranging from 4% for private equity, 8% for private debt, 14% for infrastructure right up to 28% for real assets1. This compares with steep declines seen in public fixed income and equity markets. On the flip side, this divergence of performance between public and private markets led to the “denominator effect”, altering the balance between public and private asset in investors’ portfolios away from their strategic asset allocation targets. However private credit remains a segment many investors aim to increase exposure to.
Within the broad spectrum of private credit there are different performance drivers – but also varying underlying risk factors, including credit risk, liquidity risk and prepayment risk. This is why having the right experience with the asset class can be critical.
Whilst private assets have typically generated higher returns than their more public liquid counterparts, there are unique segments within the private credit landscape that provide a best of both worlds middle ground. The liquidity characteristics of the loans and ABS markets; active secondary trading; and size, on par with developed high yield markets allow active managers to generate additional returns above income returns. These assets allow for a boost from pull to par by capitalising on periods of market dislocation whilst maintaining a complexity premium. Repayments and refinancings are quite active within these segments as the instruments are callable from 6-24M vs. 3-5Yrs for High Yield, so the pull to par cash flows come through much quicker than public credit.
These are challenging times for investors. Inflationary and recessionary concerns may continue to weigh on sentiment, but meeting long-term objectives is crucial, whatever the environment.
Dislocation and dispersion across credit markets could provide an attractive entry point for investors looking for experienced deployers of flexible, patient and long-term capital. During periods of heightened uncertainty, the flexibility afforded by lenders to go where they see the best relative value within private credit and adjust exposures accordingly can be hugely supportive for investors as they endeavour to meet their long-term goals, delivering secure income for a stable financial future.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.