Safe Money – Private Credit is Modern Fixed Income

Safe Money – Private Credit is Modern Fixed Income

Posted on Feb 11th, 2024

Inflation has risen substantially since 2021, and while not at peak levels, it may be stabilizing at a rate higher than that targeted by central banks.  In response, pension funds are turning away from the 60/40 portfolio (60% equities and 40% bonds). For those who want to take advantage of a higher for longer interest rate regime, moving beyond the traditional 60/40 (equities/fixed income) portfolio will be key. The empirical evidence we have seen suggests a 40/30/30 asset allocation is where institutional capital is headed.

Inflation Expectations?

  Source: United States Core Inflation Rates (1957-2023) (usinflationcalculator.com)

Core inflation in the U.S. appears to be leveling off near 4%, double the target of 2% set by the Federal Reserve. This data supports the idea of higher for longer interest rates. Looking back at the 1970s-1980s, inflation initially spiked up over 12% in October 1974. After decreasing to 4.8% in November 1976, it began to increase again hitting a peak of 14.7% in March 1980. It did not drop below 3% until June 1983, almost 9 years later. Even then, it was back above 3% before the end of the year and did not drop below 3% again until March 1986. This was a historic period in time, and we know history does not necessarily repeat, but it often rhymes. Even if we do not face a decade or more of high inflation, chances are it will take longer than many expect to get back to central banks’ 2% target. 

What are the larger allocators doing? Pension funds and other large asset managers are increasing their allocation to private credit and infrastructure in response to the current macroeconomic environment. The British Columbia Investment Management Corporation (BCI), the California State Teachers’ Retirement System, the Ohio Public Employees Retirement System, the California Public Employees’ Retirement System, and the New York State Common Retirement System, are just some of the many large asset managers dedicating a larger allocation to the private credit asset class and other yielding asset classes. If the big asset managers are increasing their allocation to private credit right now, this may be something for non-pension fund investors to consider. Pension funds are moving to a 40/30/30 asset allocation model which offers superior risk-adjusted performance in various inflationary scenarios. Even if inflation fades faster than most are expecting, the 40/30/30 portfolio is still expected to be superior to the 60/40 portfolio. 

KKR, a leading asset allocator, believes investors should move to incorporate more private capital right now. Their breakdown for a 40/30/30 portfolio to take advantage of the current higher inflation regime and avoid the higher volatility of public assets in an uncertain macroeconomic environment is seen below. Starting with your traditional 60/40 portfolio, substitute 20% of public equities and 10% of bonds (traditional fixed income) into 30% Private Alternatives with yield (10% Private Real Estate, 10% Private Infrastructure, and 10% Private Credit (modern fixed income)).

 

Source: KKR, Bond Capital

Advantages of an increasing yield allocation

  • Generate income – reallocate into yield-oriented alternative asset classes for ‘predictable and attractive streams of cash flow’ in private debt, as well as the other collateral-based cash flows of private real estate and private infrastructure. 
  • Preserve capital – shift to the low volatility, shallow drawdowns, and reliable inflation hedging characteristics of private credit and private infrastructure.
  • Boost real returns – in the table below, the 40/30/30 shows a higher Sharpe ratio (risk-adjusted return) in all scenarios while providing higher absolute returns in the high inflation and all periods’ scenarios.
  • Hedge Inflation – Private credit is indifferent to inflation, as it is structured with floating interest rates. Private credit delivers a real return regardless of the inflationary backdrop.

When testing the 60/40 against the 40/30/30 portfolio in three different scenarios: low inflation, high inflation, and all periods, private capital outperforms in all scenarios. During a cycle with elevated inflation, the 40/30/30 asset allocation improves risk-adjusted returns by four times. How do you justify a traditional portfolio if it underperforms on a risk-adjusted basis in all scenarios, and substantially underperforms in a high-inflation environment?

  Source: KKR               

With uncertainty ahead, we want to ensure our portfolios are positioned to weather any storm. Increasing allocation to private credit makes sense regardless of whether inflation comes down to target quickly or not. History has shown that the last mile of the inflation fight is always the hardest and tends to last longer than expected. Institutional investors know this and have begun increasing their allocation to private credit. We believe you should too. Even though private credit has been around for decades, it has caught the attention of more investors over the last couple of years. Be sure to put your trust in managers with a strong track record and experience in the asset class.

About Bond Capital

Bond Capital is an award-winning private credit fund. As a direct lender, Bond Capital provides advice and money across the entire risk curve. Bond Capital secured structured credit financing enables business owners to maintain control ownership in exchange for yield and capital preservation. Across multiple cycles and for over 20 years, Bond Capital has advanced secured investment quality credit to lower middle market companies throughout North America.