After decades of declining and ultra-low interest rates, the velocity and magnitude of global rate rises, and tightening credit conditions have dominated the investment landscape.
A direct by-product of the steepness and severity of the monetary tightening cycle, the regional banking turmoil in the US in early 2023 served as a timely reminder of the importance of managing financial risk.
Private credit offers investors the potential to preserve capital and generate resilient and regular income. It provides an opportunity to lend against high-quality assets with equity-like return characteristics, has low correlation to other asset classes and is a compelling and defensive floating-rate option to cope with the future (however that plays out).
What is behind the rise of private credit, why is it a good time to invest and what role can it play in optimising portfolio allocation?
The rise of private credit
Structural shifts in regulatory capital requirements have forced banks to be less active in certain segments of both the corporate and real estate lending market.1 This has supported the rise of private credit investment solutions.
Major regulatory changes occurred at the same time as institutional investors increased their exposure to private markets more generally in search of income yield in the prevailing ultra-low interest rate environment of the time.
The profound sustained and fundamental changes to the investment landscape is motivating investors of all types to reconsider how to protect and growth wealth and diversify outside the traditional public equity and debt markets.
The historical rules dictating asset allocation no longer necessarily prevail. Surges in 10-year bond yields and the UK gilt crisis in late 2022 led to a re-assessment of the role of public market debt in providing capital protection.2 The US banking crisis in early 2023 added a new layer of opportunity for non-bank lenders.
No longer supported by a low interest rate regime, private credit market investing offers an increasingly attractive alternative to public assets (where price and valuation are increasingly dictated by market sentiment and momentum).
With the suite of private market alternatives expanding (including private credit funds) there are increasing investment opportunities, not just for institutional investors but a wide range of investor groups including high net worth and retail investors.
Floating rate credit is well suited to current conditions
Conditions for floating rate private credit are the best they have been for a generation.
With higher interest rates, private credit benefits from the upward movement of rates occurring at the same time as the regulatory environment exerts pressure on traditional banks to secure their balance sheets.
In the hands of an experienced manager with multi-cycle experience, the position of private debt in the capital structure and its floating rate nature operates to reduce income volatility and downside risk.
Investors should choose an asset manager carefully, based on the scale and depth of their platform, the depth of embedded governance, the experience of the lending team, and an established track record through multiple cycles.
The opportunity in private credit. Challenges remain for publicly traded assets
Long-term investors have faced two major shifts in the investment environment.
One has been steadily building (the rise of private assets to the core of investment portfolios) while the other materialised relatively quickly (rising interest rates and a prolonged period of macro uncertainty).
Both require a fundamental re-think of the asset allocation process.3 The benchmark portfolio (60% equities, 40% fixed interest) took a significant hit during 2022 heralding a paradigm shift in capital allocation to a more defensive position. Private credit is set to expand its reach to occupy a greater proportion of the capital structure, and a higher allocation within investor portfolios.
Risk/Return profile for private credit
For more information about our private credit solutions, please get in touch.
1 The New Dynamics of Private Markets, Winter 2022, PGIM, www.pgim.com
2 Three US banks failed in March 2023, triggering a swift response by regulators. Source: The Evolving Nature of Banking, Bank Culture, and Bank Runs. Speech by US Federal Reserve Governor Michelle Bowman, 12 May 2023, www.federalreserve.gov
3 MSCI, Building Balanced Portfolios for the Long Run, October 2022, www.msci.com
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