Fixed income has long been the ballast in a diversified portfolio. While its returns have historically been lower than equities, investors benefit from fixed income’s stability and low correlation, relative to equity markets.
Over the last 20 years specifically, fixed income exposure helped investors amidst a period of declining and record low interest rates. Following the expected inverse relationship between bond yield and bond prices, as rates and bond yields continued to drop, bond prices rose, culminating in one of the strongest bond bull markets in memorable history.
That bull market looks to have ended, with the Barclays Aggregate Bond Index down 1.5 percent in 2021 and strong anticipation of the Fed increasing rates in 2022. In this environment, it may be prudent to reduce interest rate sensitivity in your fixed income sleeve. Adding floating rate private credit is one approach worth considering.
What Is Private Credit?
Private credit is a lesser known but growing alternative asset class comprised of higher yielding, less liquid debt investments. In private credit, entities who may have trouble securing traditional credit borrow from non-bank lenders. Private credit investors, who are the lenders in this case, expect to earn higher yields than traditional fixed income securities offer. The tradeoff is lower liquidity, longer investment time horizons and potentially higher default rates in a recession.
“For the right investors, Private Credit can be a valuable addition to a diversified portfolio”
Why Is Private Credit Worth Consideration?
Private credit offers several advantages over traditional fixed income:
- Yield Enhancement: Many of today’s traditional fixed income investments have negative real yields. This means the annual return is below zero after accounting for inflation. Exposure to private credit can boost real yields and generate higher annual income.
- Low Sensitivity to Interest Rates: Because private credit loans typically have floating rates that adjust based on changes in interest rates, floating rate loans can be protective in a rising interest rate environment.
- Diversification Benefits: While traditional fixed income is often held because of its lack of correlation to equities, that hasn’t always been the case. In some periods of high inflation, fixed income correlation with equity markets was positive for multi-year stretches. Private credit securities are less likely to have the same problem due to their lower liquidity.
Accessing Private Credit
Historically, private credit was only available to investors able to invest seven figures or more in this single asset class. Now, a variety of managed funds have made private credit available to retail investors as well.
A few considerations to keep in mind: These funds are typically less liquid than traditional mutual funds; it may take months, or even years, to redeem invested capital. Also, private credit default rates can vary, but are most comparable to those of high yield bonds.
For the right investors, private credit can be a valuable addition to a diversified portfolio, boosting yields and adding some resilience to rising rates. Investors with longer time horizons, higher yield targets and comfort with less liquidity should talk with a knowledgeable financial advisor about whether they may benefit from exposure to this underutilized asset class.
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