Private credit funds are gaining momentum as sensible additions to income investors portfolios. Generating income with private credit offers the potential for much higher income returns compared to bog-standard exchange-traded fixed income products. Importantly, private credit funds provide a way to diversify and still realise the benefits of investing for income.
Private credit funds have grown quickly in recent years. This expansion is not just in terms of volume but also in the wide range of strategies now available in the private credit market. Such strategies include direct lending to distressed debt, mezzanine financing, private equity co-investments, tranche debt, senior direct lending, senior real estate debt and infrastructure.
The rise in private credit raises important questions: How should we allocate to private credit? Is private credit truly the new superhero of the investment world? Are private credit funds poised to deliver superior returns and diversification? Is private credit just yet another trend riding the wave of current market dynamics?
Hopefully in this short article we can look at generating income with private credit and begin to unpack the role and impact of private credit for income investors.
Private Credit – What is it?
Private credit is a broad label that explains a wide range of debt-based investment strategies with different risk and return profiles. In short, you are investing in some kind of business debt. An investment into private credit normally involves lending money to companies where the borrowers receive private, non-bank loans. These borrowers often have credit ratings that are below investment grade and generally pay higher interest rates. Also, (and this is important) private credit is most often an illiquid investment, requiring investors to commit their capital over specific time frames.
Private Credit is Becoming More Popular
The marked increase of private credit over the last 15 years has been energized by factors such as economic, regulatory and market dynamics. After the 2008 GFC, banks faced much stricter regulation making it very difficult for traditional banks to lend to mid-sized companies and projects. At the same time, a low interest rate environment that occurred after the GFC encouraged investors to seek more risk in trying to find higher returns. The result of these two factors were foundational for private credit providers being able to fill the gap …. and they did.
The steady rise of private equity firms has encouraged further investment into private credit, as more of these firms have shifted reliance from traditional bank financing across to private credit to fund their deals and projects. This shift has largely grown out of the afore-mentioned tighter banking regulations and the agile, bespoke offerings provided by private credit funds. More recently, the market movements between traditional bonds and equities have become more correlated, thus private credit has gained traction as a valid portfolio diversifier for income investors, helping their risk management and portfolio income.
Supply and demand for private credit will be driven by borrowers’ need to refinance and source more capital to finance new projects and business. Demand is likely to persist, motivated by the investor allure of higher yields and the diversification advantages offered by private credit funds.
Over US$200 billion in private credit funds were raised last year, demonstrating the rising investor interest in the private credit arena.
Private Credit: Opportunities and Risks
Private credit has very clear opportunities and risks when compared with publicly traded credit products.
In the recent economic environment where interest rates have risen sharply, private credit has come forward as a formidable contender. The very structure of private credit offers a potential buffer against inflation due to its floating rate link. Simply put, this is because any bump-ups in interest rates, are transferred to private credit borrowers at the commencement of each interest rate roll period.
Specifically, this characteristic sets private credit apart from other asset classes like fixed income and real estate, which generally exhibit an inverse correlation with interest rates. For example, as interest rates rise, fixed rate bond prices normally fall.
So, as interest rates climb, fixed income and real estate investors may find it pretty challenging to secure an income yield that is viable when compared to other investment opportunities. Conversely, private credit stands to gain from rising rates, as the increases are directly passed on to borrowers.
Advantages of Private Credit
• Higher returns
• Low correlation to public markets
• Portfolio diversification
• Accesses private markets with lower risk than equities
Disadvantages of Private Credit
• Illiquid
• Potentially higher credit risks
• Higher fees
• Manager selection risk
• Less transparency / regulation
Diversification
Private credit offers fairly unique diversification benefits for income investors. Some of this benefit is driven by lending to smaller-cap companies or unique collateral structures. Private credit gives access to corporate lending opportunities that were previously not accessible to most investors, due to not being publicly listed on a stock exchange.
Whilst private credit generally displays traits of lower volatility and low correlation with traditional asset classes, this is in part, due to valuation methods. Appraisals occur periodically, unlike the minute-by-minute market pricing of publicly traded assets. This is important, as it can mask underlying risks, thus requires thorough diligence during risk assessments. Nevertheless, the reduced volatility along with the diversification benefits, can help ride and smooth market downturns,
Generating Income with Private Credit
The attraction of private credit funds for investors comes from its capacity to provide higher income returns compared to exchange-traded investment grade corporates or government bonds. This is in part due its risk profile but is also due to the ease and flexibility of its inherent transaction structures. Additionally, private credit funds often distribute income far more regularly than exchange traded products.
Private credit funds have yielded higher returns compared to most others over the last 10 years, yielding rates up to 6% higher than publicly listed high-yield corporate loans. Borrowers of private credit are willing to pay higher interest for more bespoke, borrower-friendly terms, and swift, more straightforward execution process compared to traditional bank lending. This efficiency and customisation in deal structuring make it an attractive option for borrowers, thus worth the higher borrowing cost.
Higher Income for Investors using Private Credit
Private credit often generates better total returns when compared with its exchange traded counterparts. This is driven by the higher yield potential and lower correlation with traditional market instruments. Illiquidity, strategy complexity and manager risk, all generate a premium that contribute to total return. Widely speaking, private credit strategies have exhibited outperformance over traditional fixed income investments in the long term, especially in the post-Covid rising rate environment we currently are experiencing.
In Summary – Generating Income with Private Credit
Over the last 15 years, investors have experienced significant paradigm movements in the investment landscape. Privately held assets and private credit have experienced significant growth and attention due to increased accessibility. At the same time, interest rates have risen markedly from their pre-Covid levels, coinciding with extended periods of economic and geopolitical uncertainty.
All these factors emphasise the need for income investors to reassess their portfolio asset allocation to navigate the evolving investment environment effectively. Given the uncertainties surrounding interest rates, corporate earnings and equity valuations, private credit strategies seem positioned to have a much more beneficial role in income investors’ portfolios. This is based on the inherent ability of private credit to provide higher returns compared to traditional publicly traded fixed income products as well as diversification away from traditional drivers of return. Private credit is also ideally suited to generating a steady income stream through the steady cycling of contractual interest payments between borrower and lender.
Always do your own research before investing in private credit funds due to its unique lack of detailed transparency and limited liquidity. Despite (or because of) it, generating income with private credit represents a goodly percentage of the income generating portion of my personal portfolio.
Cheers
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