Most investment portfolios have three basic components. Cash that has option value for future buys, equity for growth that hopefully exceeds inflation, and income that generates cash flow. Normally, our income investments are stable - we get some capital appreciation with predictable cash distributions. That was the case, until 2022!
Most Canadian investors have public market investment grade bonds that are essentially risk-free if held to maturity. The only risk to consider is interest-rate risk since bond prices are inversely related to the prevailing interest rate. As interest rates fall, and that has been the overall trend since the early 80s, the price of bonds goes higher. So, there has been little incentive to seek alternatives.
But with low interest rates dominating the news headlines and pundits declaring investment grade bonds as return-free risk, we figure we need to do something. If the 20-plus year tailwind of falling rates has run its course, then the only active strategy is to shorten bond durations to outperform longer duration strategies when rates begin to rise and to limit losses. If two years pays the same as 25 years, why take the duration risk? However, the one-way strategy of investment grade income investing plateaued for the past few years and abruptly ended in 2022 as interest rates started to rise. A generation of investors is now seeing double-digit declines on the “safe” income allocation in their portfolios. Now is the time to consider diversification and a look at private credit.
Private Credit is simply non-bank lending, mostly to mid-sized companies that are looking for more customized loans than the boiler-plate options provided by banks. Private lending has been around for centuries but has boomed since the Great Financial Crisis. Greater regulation since the crisis has seen banks recede from the riskier corners of lending, leaving a funding gap for private lenders to step in. This is the basis of the investment opportunity - to lend to innovative growing firms seeking to fund their intellectual property, infrastructure and real estate businesses. Potential investors need to understand that at the heart of private lending is the trade=off that it is for the long term. This has implications on accessibility, initial investment requirements, liquidity, fees and transparency.
In Canada to date, private credit options are available to Accredited Investors via Offering Memorandum with initial investment minimum of $25K to $250K. For the first 12 months you will not likely be able to redeem any funds without penalties and there is usually a schedule for maximum annual redemptions. These funding arrangements are for the longer term, usually 18 to 60 months so they are relatively illiquid investments. Fees will also vary and include a performance fee above a hurdle rate, so a prospective investor must do their research. For investors used to the reassurance of daily NAVs (net asset value), private credit investments are not mark-to-market. Instead, performance will usually be reported monthly so you will have less transparency as to the performance of your investments.
With these considerations, why should you look at private credit investments? Private lending is a well-established asset class that is growing and needs to get on the radar of Canadian investors for its higher return and diversification potential relative to the public fixed income options. Here are the top three benefits:
Higher Returns
The ultra-low interest rate environment means razor thin returns on investment grade bonds. iShares XBB ETF is a great proxy and is currently yielding less than 3% a year. In private credit, access to growing mid markets such as equipment finance, infrastructure and real estate can yield closer to 6-8% a year and most funds have that as a stated objective. Further, the underlying loans are mostly variable interest rates which offers protection to investors if interest rates continue to climb. The illiquidity premia and control over loan covenants also give private credit investors higher returns and good protections if a borrower gets stressed.
Less volatility
Investment grade bonds, usually purchased via ETFs or bond mutual funds, are marked-to-market so the value of these investments can be quite volatile. The iShares XBB ETF, which is a great tool for broad market access, is down over 11% so far in 2022 in response to rising interest rates. Private credit funds are long-term positions and are usually priced once a month, the daily gyrations of markets simply have no impact on these investments, and they generate strong and stable cash flows while investors wait for maturity.
Diversification
Due to increased regulation since the Great Financial Crisis, most bank lending now is to well capitalized and established firms in the public markets. There is a lot being written and debated about the shrinking pool of public markets investments due to the high cost of compliance and regulation. Private credit generally serves the middle market that is mostly comprised of private mid-sized companies with well established businesses. These companies can exist across all sectors of the economy and therefore provide a good portfolio diversification opportunity.
As we head into 2023 one thing is certain: that the emergency level low interest rate backdrop is over. Most investors will be looking at their public income investments with capital losses and asking basic questions about whether to add to those positions and lower their cost base or look elsewhere. Private credit is a worthy investigation since it serves a large and growing segment of the lending market. Most importantly, private credit is a longer-term commitment and is best aligned with an individual’s retirement investments. A little less market noise in one’s portfolio and higher potential returns – not a bad deal.
References:
- Mackenzie Investments “Your Guide to Investing in Private Credit” https://www.mackenzieinvestments.com/content/dam/mackenzie/en/brochures/mi-your-guide-to-investing-in-private-credit-en.pdf
- Prudential Financial, Inc. “Megatrends: THE NEW DYNAMICS OF PRIVATE MARKETS https://www.pgim.com/megatrends/private-markets
- iShares XBB ETF Product Sheet https://www.blackrock.com/ca/investors/en/products/239493/ishares-canadian-universe-bond-index-etf
