Private debt is one of the few asset classes that can offer both capital preservation and attractive risk-adjusted returns. So, in this short article we’ll see why private debt is ideal for income investors. For the record, I invest part of my portfolio in private debt. It’s the steadiest income producer in my portfolio.
Once upon a time, this asset class was only available to wholesale investors. But, in recent years, more opportunities have become available to normal investors.
I think that there are four key benefits of investing in corporate loans. These four benefits are:
1. Steady income
2. Capital stability
3. Diversification
4. Inflation proof
Private Debt gives Steady Income
Private debt can provide regular income even during periods of market volatility. My private debt holdings cough up steady income every single month.
Interest and fee payments are received from borrowers at specified intervals under the legal terms of their debt contract. If there is a floating base rate, with additional credit margin, then this ensures total interest income rises in line with market interest rates to combat inflation.
This is very different to dividends that are paid to investors at a company’s discretion. Even when stock markets were at their most turbulent during the COVID pandemic and many companies suspended, cut or reduced dividends – quality private debt funds continued to deliver their monthly income unchanged.
The private debt asset class can provide attractive risk-adjusted returns in all market conditions. Conservative private debt funds can deliver a return of around 8%. I think this is an attractive compared to corporate bonds, hybrids, government bonds or even cash. A higher yield private debt fund can deliver a cash distribution around 12%, a favourable alternative to investing in equities for income – obviously there would be some more risk associated with this level of high-income return.
When accessing corporate loan investments through a private debt funds, investors can benefit from the daily liquidity available via tradable funds on the stock market. This means investors enjoy the premium income distributions associated with this asset class, without having to lock up their capital for years, which would be the norm if investing directly into these private debt loans.
Private Debt for Capital Stability
Another positive of the private debt asset class is that it can provide capital stability through the full economic lifecycle.
Corporate private debt is a lower risk investment than equity providing that the legal terms of the debt are solid by giving priority to the interests of creditors in claims over the assets of a business. Your due diligence on this point is vital, as not all private debt is created equal.
In a private market, lenders normally negotiate directly with borrowers. A skilled lender or private debt manager will seek to negotiate appropriate terms and conditions, controls, reporting obligations, covenants and security to mitigate potential risk of loss. Covenants and ongoing borrower reporting obligations provide protection and early warning of changing risks. Security held over the borrower ensures the rights and protection of the capital rank in priority to shareholder equity and any unsecured creditors.
However, all borrowers and loans are not created equal. When it comes to investing in private debt via a managed fund, it is important to invest with a manager who has the necessary skills and experience to take the steps needed to preserve investor capital and negotiate appropriate pricing with the borrower.
Other factors that underpin capital stability include imposing appropriate reporting obligations and taking security over the company or assets. Regular monitoring of the performance of the borrower is also critical.
Private Debt provides Diversification
Sadly, many standard fixed income investments don’t deliver the safe haven and downside protection they used to do. Bonds no longer rise as equities fall (I’ve learned this the hard way in recent years) thus making the once ubiquitous balanced portfolio very unbalanced and volatile in times of turmoil.
Private debt has a low correlation with other major asset classes, including growth assets such as equities and property, as well as other fixed income products such as government bonds, providing solid diversification.
Because private debt aims to deliver reliable income and reduced capital volatility throughout the economic cycle, it can be an asset to your portfolio when other markets are volatile. It certainly has in my portfolio. It helps me sleep at night!
I choose to access private debt through a low cost, high quality and well diversified managed fund, which helps me to spread risk by investing in a wide range of business sectors, loan types, and borrowers with differing credit quality and maturity profiles. I do pay a fee for this level of quality – I think it’s worth it.
Inflation Proof your Portfolio with Private Debt
Inflation poses a real threat to investors because it chips away at the purchasing power of savings and investment returns. It is particularly damaging to returns on fixed income investments such as bonds.
Private debt offers protection against inflation because corporate loans earn their returns from fees charged to borrowers and interest that is generally charged at a floating rate. The interest on well managed corporate loans is usually structured as an additional margin over and above prevailing bank rates.
Private Debt is Ideal for Income Investors
I use good quality private debt funds in the cashflow part of my portfolio to provide me steady, monthly paid income. These do the heavy lifting of paying my basic bills every single month. My experience over the years is that carefully researched and selected private debt is ideal for income investors. Your research, circumstances and mileage may well differ – so do you own due diligence.
Cheers
