Investors who allocated to and rebalanced into Private Credit / Direct Lending have found one of the few bright spots this year. Public equities and public fixed income have declined in tandem leaving investors battered. Low correlation private credit looks to continue its recent performance for three reasons: Firstly, large asset managers are rebalancing their portfolios back to their target allocations which means away from alternative assets and into more public debt and equities. Secondly, central banks continue to run off their balance sheets or engage in quantitative tightening (QT). Thirdly, the rising interest rate environment will improve private credit returns as they are largely floating-rate loans benefitting from higher reference rates.
We know that private credit strategies enhance fixed income, provide diversification benefits with low correlations, and offer a reliable income stream with capital preservation. What is unusual about recent returns is that they have also been strong when compared to public equity returns.
Large asset managers tend to have target asset allocations. For example, CalPERS, one of the largest US public pension funds, has the following target allocation:
77.6% of CalPERS assets are in public bonds and equities which have fallen significantly. To maintain their target asset mix they will have to sell other assets which increased in value to rebalance their positions to their target. In essence, their asset base has fallen, and they will have to sell other assets including private debt to rebalance. This will lead to a shortage of private debt, reducing competition in private credit, and enhancing returns therein.
As the pandemic started central banks sought to stimulate the economy with capital by keeping interest rates low and by buying financial assets through a process called quantitative easing (QE). This forced financial institutions and investors to invest in riskier assets to see competitive returns.
Now that central banks are increasing interest rates, they are beginning to reverse QE–through QT. QT will reverse the effects of QE, which inflated the value of risk assets. Financial institutions such as banks will look to safer assets to meet regulations, or they will hold higher-cost capital to offset risk and deflated asset values. A reduction in the availability of credit will affect Small and Medium Sized Enterprises (SMEs) more acutely than those who have access to public capital markets.
Lastly, private debt typically has an attractive credit risk profile due to the credit enhancements negotiated in each custom transaction. Private debt minimizes the risk of rising rates as returns are primarily based on a floating reference rate plus a spread. Additionally, unlike traditional public market bonds, private debt can negotiate credit enhancements like positive covenants and interest rate minimums (also known as floors) to further mitigate risk. These features enhance its attractiveness as an asset should market conditions change. Increasing interest rates coupled with a lower supply and muted competition in the market indicate continued outperformance for private credit.
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 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.