Private Credit’s Time to Shine? Exploring Investment Returns, Credit Spreads, and Equity Returns in 2022
Private Credit’s Time to Shine? The year 2022 proved to be challenging for fixed income investors, as interest rates rose and central banks tightened their monetary policies, leading banks to pull back and, in some cases, face failure. The slowing economy added to the stress, resulting in diminishing returns for assets. Furthermore, persistent high interest rates, coupled with banks’ retrenchment, have widened credit spreads for borrowers. This, in turn, is causing existing credit facilities to be refinanced at higher rates, further decreasing returns on equity. However, as lenders are finally getting compensated for their lending, and considering the risk-adjusted basis, credit returns may now outperform equity returns. As of April, the target United States Fed Funds rate stands at 4.75-5%, leading to losses for banks with longer-dated bonds on their balance sheets. Consequently, depositors are moving their money to more solvent banks or instruments offering higher rates. This has led to intense competition for deposits, which has caused some smaller banks, such as Silicon Valley Bank, to fail. The banks’ search for liquidity and concerns for duration risk has resulted in them holding onto capital, rather than lending into the economy. Meanwhile, despite low unemployment rates, inflation remains high, causing profit margins to shrink and leading to a drop in return on assets. As interest costs rise, returns on equity are also expected to decline. Given these trends, it is expected that investment returns will shift towards different asset classes than those that have prevailed over the past five years. Traditional fixed income investments are likely to perform better, due to the increase in interest rates. However, private credit is expected to benefit even more, since its returns are tied to floating rates, which have increased. Moreover, credit spreads for private credit are expected to improve due to the lower liquidity of banks due to ongoing conservativism and deposit competition. Higher returns are expected for private credit, albeit at the expense of equity returns. Private credit is now poised to shine and could prove to be a lucrative investment option for those seeking non-correlated diversity with higher returns in the current economic climate of slower growth with a higher cost of capital. Is this private credit’s time to shine?