Risk-Adjusted Returns

Risk-Adjusted Returns

Posted on Apr 30th, 2024

Over the last several decades investors have diversified their asset allocation and in doing so incurred additional risk in order to maintain returns. Inflation risk has risen and so investors are increasingly considering real returns in their portfolio construction. Institutional demand for real returns has driven demand for private credit as an asset class to generate risk-adjusted real returns. Non-institutional investors should take note and consider allocating to private credit.

The complexity and risk required to achieve the same level of return has increased over the years. According to Callan, in 1993, to achieve a 7% nominal return over the next 10 years, an investor could have had 97% of their portfolio in bonds and 3% in large-cap US equities. In 2023, the same investor would need to have 33% in bonds, 25% in large-cap US equities and the remainder in a combination of higher-risk assets such as small-cap US equities, non-US equities, and alternative assets. Alternative assets most commonly including private capital, and real estate. Unfortunately, the risks taken on by investors, measured in volatility, of this portfolio have gone from 6.2% in 1993 to 11.8% in 2023, almost doubling and certainly troubling the modern investor. Institutional asset allocations now reflect this drive to diversify into alternatives.

Source: Callan, Bond Capital; each square represents 1% allocation

Given the current inflationary environment, it is useful to think about real (inflation-adjusted) returns. In 1993, using inflation expectations of 4% for the next 10 years, an investor could have achieved a 5% real return with 8.8% portfolio volatility. In 2023, using inflation expectations of 2.5% for the next 10 years, to achieve the same 5% real return an investor’s portfolio volatility would be 14.9%. 30 years ago a 5% real return could have been achieved with public bonds and equities, today’s portfolio needs to include alternative asset classes to do the same. Current trends in alternative asset allocations are seeing increased allocations to private credit to reduce risk, mitigate inflation, and skirt current structural challenges in both real estate and private equity that are the legacy of our recent zero interest rate policies (ZIRP). One might argue private credit be moved out of the alternative asset category and into the fixed income category as a “private bond”.

To achieve the same returns as in years past, institutional investors are looking to private credit for high-quality, real yields. An allocation to investment-quality private credit can help boost returns while reducing risk. Private credit’s “principal” component provides a safe contracted value store with the “interest rate” component bringing reliable cash flows and an illiquidity premium over public bonds. Together the principal and interest offer greater diversification through a lower correlation with public market equities and traditional bonds. These features help reduce portfolio risk without compromising on returns, allowing investors to achieve the goal of better overall risk-adjusted returns. Private credit outperforms in rising rate environments due to the floating rate structure prevalent in direct lending transactions. Alternatively, if interest rates are falling due to lower inflation, real returns are locked in. However, an experienced direct lender will structure transactions with an interest rate floor, so real returns would increase as interest rates drop. For these reasons, we believe the empirical evidence shows why investors should consider reallocating a portion of their current public bond, real estate, and private equity holds into private credit.

Source: Bond Capital

As a maturing asset class, there is now a robust private credit data set from multiple sources. This data informs us that private direct lending loans underwritten by experienced managers able to negotiate stronger protection result in lower loan losses when compared to other credit classes such as leveraged loans and high-yield bonds.

Returns in High Interest Rate Environments

Source: Morgan Stanley, Bond Capital
* Return data for the period from Q1’08 to Q2’22. Calculated as annualized average returns divided by volatility. Volatility is measured using standard deviation.
* High interest rate environment defined as 6 time periods (1Q’09-2Q’09, 4Q’10-1Q’11, 4Q’12-4Q’13, 3Q’16-4Q’16, 3Q’20-1Q’21, and 3Q’21-2Q’22) when rates increased by 75bps+.

Private credit generated higher returns and lower loan losses. The size of the private credit market was $875 billion in 2020, $1.4 trillion in 2023, and is expected to reach $2.3 trillion by 2027. Global equity market values were estimated at $124 trillion for 2021 versus $10 trillion for private markets, according to SIFMA and McKinsey. There is ample room for growth in alternative assets if investors transition a fraction of their equity assets into alternatives. Good investors regularly rebalance to go where the growth is.

Loan Losses

Source: Morgan Stanley, Bond Capital
* Loss rates represented by period (Q1’20 to Q2’22). Default and Recovery rates are sourced from Moody’s.

We are living in an uncertain economic environment and times of relative calm are often followed by periods of volatility. With inflation proving to be stickier than expected, investors need to position their portfolios to provide the best risk-adjusted returns in all weather. Private credit can help decrease portfolio volatility, increase returns, amplify capital preservation, and provide a hedge against both rising and falling interest rates. Prudent investors should get off zero and allocate as much as 20% of their portfolio to private credit to lower risk and manage up their returns.

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.