The frictionless movement of assets is becoming a common feature of markets around the developed world, yet Australia remains a step behind. The ASX is in no mood to rush the move to T+1, however, after its calamitous attempt to implement distributed ledger technology.
It’s a dire situation for consumers but a massive tailwind for financial advisers. More people and more capital in the superannuation coffers than ever, with a stubbornly small number of advisers to service them.
Why private credit is a double-edged sword
The past five years have seen an explosion in allocations to private credit both in Australia and globally, with investors initially attracted by the high yields on offer as developed bond markets struggled with low rates. But as interest rates rose in 2022, private credit continued to attract significant inflows from investors (albeit at a lower rate). Is the enthusiasm justified?
The greatest attraction of private credit is its high yield and high return. The most commonly used benchmark for private credit, Cliffwater Direct Lending Index for Private Credit, reported an 8.8 per cent annualised return from 2016 to 2022. significantly outperforming the anaemic 0.9 per cent return generated by US investment grade bonds and the even lower 0.1 per cent return generated by global aggregate bonds during the same time period. The most significant outperformance took place in 2022 when interest rates rose sharply, and private credit returned 6.3 per cent while global investment grade bonds fell 16.2 per cent.
But there are reasons to be cautious in chasing the stellar recent past returns. Private credit’s large outperformance in 2022 partly reflected its lack of duration, which can be a double edged sword. Traditional bonds underperform relative to private credit when interest rates rise – as long as credit conditions remain benign. A recessionary environment will likely lead to private credit underperforming traditional strategies (developed sovereign bonds and investment grade corporate bonds) as yields fall and credit spreads increase. Secondly, private credit is about lending to corporates, in particularly smaller corporates. Are investors sufficiently compensated for taking this credit risk?
A simple but useful approach is to compare private credit with the most similar traditional fixed interest assets: US syndicated loans. Both assets represent lending to smaller companies, often without investment grade ratings; both are floating rate securities; and both assets sit higher up in the capital structure of a borrower.
Higher demand = declining credit quality
But while private loans are offering a higher yield of 246 basis points as at end of 2023, this yield advantage must be interpreted with context. This yield spread has eroded steadily from 350 basis points at end of 2013. One of the drivers of this decline is the huge amount of capital chasing private credit borrowers. The level of ‘dry powder’ (committed but uncalled capital) sitting in private credit funds rose to more than US$400 billion by September 2023 according to Standard & Poors. While it is true that demand for private credit from borrowers has increased due to tighter regulation of traditional banks, past experience in asset markets suggest that borrowers chasing lenders leads to declining credit quality and higher risks.
In fact, there are good reasons to suggest that even the 350 basis points yield spread for private credit loans in 2013 might only be fair, and not superbly attractive, compensation for the extra risks which private credit investors take.
The first reason for that is that private credit loans may be riskier than syndicated loans because of the smaller size of the borrowers. Private credit borrowers are often smaller corporates with EBITDA of $25 million to $100 million. The average interest coverage ratio (ICR, which is a key liquidity risk metric) in private credit has also declined significantly to around 2.0x by September 2023, compared to around 3.0x two years earlier. For comparison, ICR in US syndicated loan borrowers stood at around 2.7x as of 2023. Admittedly, studies on the default and recovery history of private credit are inconclusive on the question of its riskiness relative to US syndicated loan.
Another reason for caution is the increasing popularity of unitranche structure in private credit. Unitranche is a hybrid loan structure that combines senior and subordinated debt into one debt instrument. The main benefit is higher interest rate and return for investor but under such a structure, there is no longer any senior debt which depends on more junior creditors to take the first hit.
Liquidity and (ir)rationality
The other difference is the inherent liquidity risk (or the lack of liquidity) for private credit investors. Admittedly, the price of liquidity differs for different investors, depending on their portfolio, cashflows, need for income etc. Investment in private debt mostly involves investment in a lock-up vehicle with limited liquidity (usually through quarterly redemption windows). In non-investment grade corporate credits or leveraged loans there are markets in which investors might trade and liquidate their investments – albeit at a discount if one is a distressed seller – if there is the need. But investors can only exit private credit via more time consuming and likely more expensive private negotiations.
Investors must also be careful in how they interpret return data from private credit funds, avoiding the exaggerated claims made about the low correlation between private credit (and, for that matter, any private assets) and traditional asset classes. The claims about diversification are often exaggerated, and based on stale pricing from a lack of “mark to market” valuations. If investment grade corporate credit is trading at lower prices, economic and corporate fundamentals are being recognised by buyers and sellers who have their capital at risk. Price movements in any listed markets can be exaggerated or irrational in some case, but this is different from claims that re-valuation on a monthly or quarterly basis, or when there is a credit event, is a better reflection of economic reality.
Another issue that investors should be aware of is the difference between leveraged and un-leveraged returns, since some private credit funds use leveraged to “juice up” returns. The level of leverage differs between funds. In the aggregate, private credit funds borrowed about USD$200 billion in the end of 2021 – a significant amount in the context of total private credit funds (AUM of around USD$1 trillion).
Still, despite some of the concerns raised about the use of private credit in a portfolio, it has some attractive characteristics, particularly compared to other private assets. Its pay-back period is shorter due to a combination of a shorter draw down and the relatively shorter maturity of loans and is less vulnerable to manipulation in valuation. It also offers a steady stream of cash inflows in the form of interest payments. If investors are willing to accept a higher level of drawdowns during a recession and greater illiquidity in return for higher intertest payments, it has a role to pay in an income portfolio. Just don’t expect private credit to behave like developed sovereign bonds or investment grade corporate bonds.
