What role does private credit play in long-term portfolios?

Private credit can command a yield premium over its public credit counterparts due to its flexible, speedier underwriting, and non-tradable, illiquid nature compared to traditional bank syndicated loans. These characteristics allow it to generate a steady stream of income throughout cycles, as we discussed in a separate article. For long-term investors, adding an allocation towards private credit helps to improve the risk-return characteristics of a portfolio by improving expected returns and reducing overall portfolio volatility.

For starters, we review the returns over the last five and ten years respectively. Private credit has outperformed high-yield public credit by 550 bps and 460 bps respectively, according to a report by Brookfield Oaktree. 

From a yield perspective, direct lending is able to command an average yield of 11.6% p.a. versus 7.9% p.a. for high yield credit, or about a 370 bps yield pickup. Here, private credit is referenced by the Cliffwater Direct Lending index, and high yield by the ICE BofA US High Yield index.

Diversifying with private credit in a 60/40 portfolio

Given the higher yields and diversification potential, private credit can help increase a portfolio's income potential, when added to a portfolio of traditional public assets. With its exposure to private companies and a lower duration compared to public credit due to its floating rate nature, private credit - when added to a portfolio - also provides a less correlated source of return, further enhancing portfolio diversification. 

All this is given of course that the investor has a long-term investment horizon and can afford to hold less liquid assets as part of his or her goal. 

Let’s take a traditional 60/40 portfolio, for example. Now by adding 20% in private credit direct lending exposure (reducing 5% from equity and 15% from bonds), the annualised return would increase from 7.2% to 8.6%, while the resultant annualised volatility would fall from 11.8% to 10.7%. This is possible because of the higher yield and return arising from the structural illiquidity of the asset class, as well as the low correlation of private credit to the public bonds and equities acting as a dampener which reduces overall portfolio volatility. 

Put simply, we are able to increase the return potential of the portfolio, while simultaneously reducing the level of risk. Altogether, the addition of private credit direct lending to a traditional 60/40 portfolio can help improve the risk-adjusted returns and lead to better portfolio outcomes over time. 

Lower volatility and downside risk mitigation

One question which then naturally arises is why private credit is able to achieve a lower level of volatility compared to public market fixed income.

Referring to the historical risk and return matrix below, we see that within the credit space, direct lending has one of the lowest volatility profiles, even lower than that of US aggregate bonds and leveraged loans. Let’s examine a few reasons for why this may be the case. 

One of the reasons for this is that private credit direct lending typically comprises loans which are senior in the capital structure and typically secured by first-lien collateral, making them more defensive in nature. Of course, there are also varying levels of seniority and types of collateral, which may alter the risk profile of direct loans. Nonetheless, if we inspect private credit offerings available today we observe that a significant portion of the assets are in first-lien, senior secured loans - and hence we will focus on this segment. 

In the event of a default, senior direct loan holders are typically paid before junior debt and equity holders, significantly reducing the chances of loss by staying high up in the capital structure. In the case of senior secured first-lien debt where the company is also sponsor-backed, the perceived risk of default becomes much lower as the general partners (GP) can also provide help during more troubled times. 

Typically, there is also a long-term relationship between lender and borrower which allows the borrower to work with their lender to renegotiate or restructure a loan if needed during the loan’s life, thus lowering the probability that the borrower defaults. Similarly, it is also common for the lender to have restrictive covenants in place to protect itself. If we look at the data on loss rates, direct lending has historically exhibited a low loss rate of 1.02% p.a over the last 20 years. By comparison, high yield bonds have a higher loss rate of 1.96% p.a over the same time frame.

The second reason is that private credit comprises a portfolio of illiquid loans which are not publicly tradable, and are therefore not subject to the same mark-to-market volatility as their public loan counterparts. 

In contrast, public market fixed income and loans would typically fluctuate more readily on a day-to-day basis, depending on market demand and supply. Because private credit direct loans are valued less frequently - typically monthly or quarterly - this leads to a lower level of volatility in their valuations. 

Lastly but importantly, because these private loans are typically floating rate and benchmarked to 3-month reference rates, they therefore have a very low duration risk and hence a low sensitivity to interest rates. For instance, compared to fixed rate loans, when rates rise the higher interest payments in private credit would help to better protect the current value of the loan’s coupons, leading to a lower volatility profile than fixed rate loans. This results in a low correlation with public fixed income.

The upside of this is that if we complement private credit with other public fixed income instruments in the portfolio, we would naturally improve the diversification potential of the overall portfolio.

These structural characteristics of seniority, low duration sensitivity, and not being readily tradable allow direct lending loans to maintain an overall lower volatility profile while maintaining a higher level of income and return.  

Dispersion of returns, dispersion of private credit manager quality

When selecting a private credit investment, it is important to consider a diversified approach and not place an outsized position in one fund vehicle. Selecting top-tier managers with a strong track record of producing stable returns through an investment process that is consistent and repeatable is important. 

A study by Blackstone showed that if we look at the dispersion of returns in private credit across managers, there is about an average performance dispersion of 5.2% between top-quartile and bottom-quartile managers. 

It is therefore critical to conduct proper due diligence to ensure the manager has a consistent, sustainable process and does not take unnecessary risks to chase for yield. 

One also needs to differentiate among the sub-asset classes within private credit, be it direct lending (senior or subordinated), mezzanine, or special situations/distressed, as they each have distinct risk profiles. While the focus of this article has centred on direct lending particularly in the senior secured segment, other categories of private credit would have different risk profiles that one should conduct further analysis on. 

Within the portfolio, some factors to consider are seniority in the capital structure and what proportion of loans are senior secured, the average EBITDA profile of the borrowers i.e. upper middle, middle or lower middle market, what type of collateral is pledged and is it first or second-lien, what percentage of the investments are sponsor-backed versus non sponsor-backed, and are there any sectoral and geographical concentrations, among others factors to be considered. 

For more information on each type of sub-asset class within private credit, please visit our previous article written on an introduction to private credit. https://endowus.com/insights/private-credit 

Conclusion

Putting everything together, we see that private credit continues to remain an attractive portfolio diversifier which can help improve the overall risk-adjusted return of a traditional equity and fixed income portfolio. 

Direct lending, which makes up the bulk of the asset class, is typically senior secured and therefore relatively defensive in nature. Historically, direct lending has been able to outperform public fixed income by roughly 450 bps p.a. over the last 10 years, as we have seen. 

At the same time, it has been able to maintain a lower volatility profile due to the seniority in the capital structure, structural advantages that keep loss rates relatively low, low duration sensitivity, as well as not being subject to daily mark-to-market fluctuations. While interest rates are likely to trend lower in the upcoming quarters, history points to the resilience of the asset class in its ability to maintain a relatively attractive level of income throughout the cycle - including during zero to low-rate environments. 

This is an important consideration for income-oriented investors, who are looking for an attractive level of income relative to their public fixed-income portfolios. Importantly, the structural growth in the asset class and the improving M&A landscape would bring tailwinds to the asset class and result in more interesting investment opportunities ahead, underpinned by a continued strong investor base. Importantly, the addition of private credit to a traditional equity and bond portfolio would help achieve better portfolio outcomes by improving overall portfolio return potential and reducing the overall volatility.