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Wealth & Investment Management

Diversifying fixed income portfolios with private credit

Posted by on 18 June 2024
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The resurgence of yield has created a compelling case for investors to revise their strategic credit allocation. A diversified credit portfolio, with private credit complementing core fixed income exposures, can enhance return potential. Ongoing uncertainty remains around the trajectory of inflation, timing of interest rate cuts, and broader structural realignment driven by five key structural forces: decarbonisation, digitisation, deglobalisation, destabilisation in geopolitics, and demographic aging. Against this backdrop, diversification and careful manager selection can help investors navigate these contours and construct resilient, return-focused portfolios.

Expand your horizons with private credit

For investors willing to look beyond public capital markets, private credit has developed into a diversified asset class with opportunities across the borrower, credit quality, and risk/return spectrums and term structure. The asset class offers enhanced yields, insulation from near-term market volatility, and diversification benefits. In addition, the asset class can provide some inflation protection, since private credit instruments are often tied to floating rates, making them less sensitive to interest rates compared to fixed-rate bonds.

While the majority of private credit assets under management are currently in corporate lending, the asset class also encompasses diversifying strategies such as real asset credit and asset-backed and specialty finance. These strategies feature varying risk/return profiles and degrees of sensitivity to the economic cycle. Real asset credit may lend to property types levered to long-term secular trends or idiosyncratic supply/demand dynamics, while asset-backed and specialty finance lenders provide loans backed by equipment and other tangible assets, future revenue streams like royalty payments, or financial asset pools such as consumer and residential lending. As such, they can offer diversification and low correlation to corporate credit. We believe asset finance is a segment of the market growing in importance.

A framework for private credit portfolio construction

Private credit strategies can play different roles in a portfolio, in alignment with the overall asset allocation. As such, we believe investors should look beyond a single, monolithic definition of private credit, employing a granular and sophisticated approach to allocating across private credit strategies. One framework is to draw parallels between private credit investment strategies and their closest counterparts in public markets. This can help define portfolio characteristics, roles, and diversification approaches. Private credit portfolio construction may not easily lend itself to relying exclusively on traditional mean/variance portfolio construction techniques. We believe the process should delve further, evaluating not only the magnitude but also the nature of risks in each strategy, diversifying across the underlying sources of risk, and considering the tradeoffs the investor wishes to make among them.

New fund structures can make private credit more accessible and allow for more dynamic asset allocation. For example, the semi-liquid market can offer immediate private market exposure and yield with periodic liquidity (subject to gates and queues), and reinvestment of proceeds to facilitate compounding of capital over time.

Today’s market environment

We believe risk-adjusted returns should remain attractive, albeit with growing dispersion among individual credits. Rate compression may be more modest than previously anticipated, with fewer rate cuts coming later than initially expected. This may be somewhat offset, however, by tightening spreads.

Changing supply and demand dynamics in private credit are driving an evolving opportunity set. A rebound in syndicated market volumes and strong investor appetite for private credit, including from semi-liquid vehicles, may pressure underwriting terms in the near term. However, we believe improving corporate optimism should stimulate M&A activity and new debt issuance, bringing supply and demand back into balance over time. As PE mega-funds seek to deploy capital, larger companies may become more frequent targets, calling for financing solutions at scale.

In corporate private credit, payment defaults and losses have been muted so far this cycle. Borrowers’ operating fundamentals have remained largely resilient, supporting debt servicing – and we believe that a benign macroeconomic environment should continue to provide a tailwind for company fundamentals. Distress has ticked up, however, pointing to greater dispersion amongst individual borrowers and loans. In many cases, distressed situations are being worked out privately between the original borrower and lender. The bilateral nature of private credit has allowed borrowers and lenders to proactively address potential distress and therefore mitigate defaults. Furthermore, many borrowers are backed by financial sponsors that have supported their assets through distress to protect their equity investment.

In commercial real estate (CRE) private credit, concerns stemming from higher rates, office vacancies, and fears around access to capital have not escalated into widespread stress. While Office CRE continues to face challenges, other property types, like industrial assets, exhibit strong credit and operating performance.

We expect the relatively benign default dynamic should continue, as business with prudent capital structures and stronger cash flows should be able to withstand a higher-for-longer interest rate environment. On the other hand, the environment should test some fully-levered companies and business models. Strong businesses with balance sheets unsuitable for the current rate environment may drive demand for creative structured financing solutions, including hybrid capital. Underwriting, structuring discipline, robust sourcing pipelines and experience should become a greater determinant of ultimate outcomes, in our view.

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