Private credit offers variety and diversification for fixed-income investors

It's been hard to navigate investment markets lately. Volatility in the stock and bond markets puts pressure even on investors with long time horizons. Inflation eats into returns from traditional safe harbours like bond markets. So investors are left asking where to go for reasonable returns and some protection from the vagaries of the markets.

It turns out that they don't need to venture too far afield. That's because private markets for equities and bonds have been growing fast - and access to these asset classes has become markedly more democratic. For investors seeking diversification, private credit provides the shock-absorber stability of fixed income alongside attractive long-term returns. 

Bonds that are not traded on a public market, also known as private credit, provide capital to privately held companies. Most companies use some debt to finance operations and fund growth. This debt can be raised through a bond issue or a bank loan, but access to these sources of capital has been shrinking in recent years. For small- and medium-sized companies, privately issued debt has become an important source of financing - and as a result, a growing asset class for investors.

A subset of fixed income

It's best to think of private credit as a subset of the general credit or bond asset class. That's because private bonds look similar to the traditional corporate bonds that are traded on public markets. Any bond is a loan that a borrower agrees to repay at the end of a set period, while typically making an annual or semi-annual "coupon" payment to the holder of the bond at an agreed interest rate.

Investments in private credit can be used to diversify private equity or traditional portfolio allocations such as fixed income. Since returns from private credit are not correlated with  public bond market movements, they offer a potential source of portfolio diversification and stability. At the same time, private credit can be an excellent stand-alone allocation in a portfolio because its different strategies offer a range of risks and returns that are broader than some other private asset classes.

Illiquidity premium

Private credit also offers an illiquidity premium. Because there is no public market for these bonds, a secondary market is not necessarily available. So investors must bank on holding these instruments to maturity - and are able to ask for an additional sum known as a premium as a result. Stephanie Meili, senior private markets advisor EMEA at LGT Private Banking, says, "Even though the illiquidity premium of the direct lending market has compressed relative to other historical periods, it remains positive."

Unlike many bank loans or even most public bonds, private debt is a customised transaction between the lender and the borrower. This means that the transaction more closely meets the needs of both borrower and lender in terms of pricing structure, terms and conditions, and collateral. It also provides an opportunity to incorporate effective downside protection for investors. Critically, this tailoring of terms results in lower default and higher recovery rates.

Flexibility and adaptability

"Private credit providers are often much closer to the management teams at the borrower," explains Meili. "It's a much more engaged process, allowing the structure to be amended throughout the life of the loan if necessary, to ensure that the borrower can service its debt obligations." This flexibility is not available in the public markets, where a high yield bond issue may be held by hundreds of investors at any point in time, making it difficult to agree on potential amendments.

Avoiding technical signals

Private credit, with its hold-to-maturity ethos, offers investors a degree of stability that can be hard to find in publicly held fixed income investments. Because direct loans are typically not sold, the asset class is insulated from the sort of technical selling pressure that is typical during down markets in more traditional, publicly traded assets. "Limited liquidity in public markets leads to a disconnect between prices and fundamentals at inopportune times," says Meili. "This dilutes some of the key benefits of fixed income, which is to preserve liquidity."

Explosion in growth

The private credit market owes its rapid growth to the changes in capital markets since the global financial crisis. More stringent capital and regulatory requirements mean that banks have a reduced appetite for traditional lending, and the public bond markets are focused on larger companies. According to Preqin, a global research company that provides data on alternative assets, investors have allocated about USD 1.5 trillion to the global private credit markets, representing a seven-fold increase since 2007. This figure includes a range of different types of private credit, representing different levels of risk, from venture, special situations and distressed debt, to mezzanine and direct lending.

The growth of private credit mirrors the rise and increasing sophistication of the private equity and mergers-and-acquisitions markets. As a comparison, private equity sponsors have nearly USD 2.5 trillion in cash waiting for deals, according to Preqin. Many of these deals will require private credit lines to complete. 

Shorter lifetimes

Private credit is used most frequently in US middle market companies, but it is fast becoming a financing tool of choice in Europe, which has an enormous tranche of these medium-sized businesses. It is also growing in importance in Asian finance.

Investors familiar with private equity investments will find that private credit investments use very similar closed-end structures, although with a shorter lifetime, and have a shorter payback time than their equity counterparts. Investors typically commit funds at the outset and credit managers, known as sponsors, draw down these funds over the first years (often four years for private credit in contrast to seven to ten years for private equity). Payback in private credit investments often starts within three to four years, because the investment will include a variety of short- and medium-term paper. Private equity commitments often don't start substantial distributions until years five to seven, continuing to years ten to 12.

Of course, all investments involve risk, and private credit is no exception, which means it is suited for experienced, professional investors only. Private credit financing is generally used by small- and medium-sized companies, often rated less than investment grade, so there is a risk of capital loss. These risks can be mitigated by the close cooperation between borrowers and lenders that can highlight issues before they become critical. The downside can be protected through the use of appropriate covenants.   

Hold to maturity

Illiquidity is both an attractive quality and a risk. Less liquid investments like private credit notes and the investments in which they sit offer a benefit in the form of generally higher returns. But investors do need to be prepared to hold these investments to maturity. Leveraging these investments, while offering the potential to enhance returns, may also magnify losses. That said, fixed income investors can find variety, stability and diversification in private credit markets.