Is private credit the best resource in these uncertain times?

Investors are increasingly seeking alternative strategies as traditional public markets fail to produce expected returns

The diversity of instruments within the private credit asset class offers a potential opportunity for investors with varying risk appetites and portfolio objectives. EPA

The current market volatility and mounting economic anxiety, fuelled by the combination of post-coronavirus global inflation, rising interest rates, extensive lockdowns in China and the war in Ukraine, are substantially affecting investors’ outlooks.

It seems unlikely that the return drivers of the previous decade will generate outsize returns for the next decade.

With traditional public markets failing to produce expected returns, we have observed increasing investor interest in alternative strategies, particularly in private credit.

A range of fixed-income instruments with differing return profiles sit under the private credit umbrella. Private credit strategies can either be bond-like or equity-like.

We believe this diversity makes private credit a potential opportunity for investors with varying risk appetites and portfolio objectives.

Senior direct lending makes up much of the private credit market today. This form of direct lending is “senior” as holders are prioritised for repayment in the event of a default.

Direct lending is used to finance middle-market businesses (typically, private equity sponsors use direct loans to finance acquisitions).

Additional types of private credit include real estate loans, “special situations” and other niche, specialised credit strategies.

Private credit is now easier to access

While private credit is not the most well-known asset class, it has expanded in the past decade, driven by increased demand from investors and borrowers, and now approaches the size of some public fixed-income markets.

Private credit yields are usually higher, due in large part to restrictions imposed during the 2008 global financial crisis. Private market borrowers are compelled to pay higher rates as they lack liquidity and are unable to acquire bank loans.

Large institutions were early to the private credit market, seeking higher yields when they were not available in traditional (public) fixed-income markets.

Now that the market is larger, more established and easier to gain access to, we have observed rising demand from private borrowers as well.

Higher returns and income generation

Traditionally, investors have relied on bonds and loans to generate income. However, bond yields, although rising, remain historically low.

Direct lending has historically been characterised by stable, forecastable income flows. Additionally, it also has a relatively lower risk profile than other types of private credit, with lower returns.

Lenders have a priority for repayment with “senior” direct lending and loans are frequently secured.

Direct loans typically pay floating-rate coupons, although with “floors” in low-rate environments. These features have helped direct lending to generate more favourable returns, with greater consistency than other kinds of debt.

Funds that hold these assets typically add leverage (invest with borrowed funds), increasing return potential as well as risk.

Since there is less transparency in private credit than in public bond markets, managers must have strong credit research and underwriting capabilities to select high-quality companies.

Special situations and distressed credit

If you are seeking to potentially enhance returns, have a higher risk tolerance and want an alternative for equities — or diversify your equities exposure — consider special situations and distressed credit.

Similar to “buying low” in equities, here deeply discounted, “stressed” debt may be purchased from a current owner or a high-interest loan may be issued to a distressed company.

Occasionally, the lender anticipates acquiring ownership when the company’s value has risen. While a company regains its footing, distressed credit may take the shape of a “bridge loan” or another bespoke solution.

Contrary to senior direct lending, which has the lowest risk-to-return ratio, special situations and distressed credit strategies seek higher absolute returns via increased risk, in the security and/or the company.

Distressed credit may be “junior” (lower in priority for payback).

Generally, special situations and distressed borrowers are going through a transitional phase and need capital. Perhaps the company experienced challenges related to the Covid-19 pandemic or the management made mistakes.

These strategies frequently lack a current income or yield component (although some do). Investors take this into account and seek to build in compensation, structuring the credit to have a higher total return.

Mitigating risks

Private credit is less transparent than bonds and is not rated by credit rating agencies. As interest rates are adjustable with market rate conditions, borrowers may be strained when market rates rise, as is the case with many other debt instruments.

For investors, holding floating-rate credit when rates are rising should prove beneficial.

If private credit matches your requirements and investing goals, all these qualities make it a compelling opportunity.

Steven Rees is the head of investments for the Mena region at JP Morgan Private Bank