Partner/Managing Director, NewEdge Wealth.
I believe we’re either on the brink of, or in the midst of, one of the most significant secular bull markets in history. This period of economic growth and rising asset prices has also come with dramatic shifts in interest rates.
The way companies obtain funding has completely shifted and we’re seeing the rise of private credit as a result. By adapting their strategies to the changes in the market, investors can build portfolios that thrive.
Understanding The Rise Of Private Credit
The low interest rates of the past decade provided cheap financing for companies that rarely needed to turn to private credit. Stricter regulations came after the 2008 financial crisis, particularly concerning banks’ capital requirements, which significantly reduced their risk appetites for loans.
This made banks pull back from the leveraged finance market. Since then, private credit has grown considerably as an asset class. Returns have more than doubled, with current yields ranging from 10% to 13%.
Depending on credit quality, private credit holds an impressive average of 200 to 600 basis points higher than public markets. The lack of correlation between private credit and public markets also helps to reduce volatility during periods of market stress. This was evident during the pandemic and the market downturns of 2022, where private credit investments experienced less volatility compared to other forms of credit.
One reason for this resilience is the nature of private credit. These loans are typically non-traded, meaning they are not subject to the same market pressures as publicly traded assets. Additionally, private credit deals often include covenants and other protections that help mitigate risk in challenging economic environments. For investors looking for a stable income stream with lower volatility, private credit is a fantastic opportunity.
Broadly Indexing With Private Credit Allocations
Integrating private credit into broadly indexed portfolios is an opportunity for investors to diversify in a market where the search for yield has become more challenging.
This means allocating a portion of an investor’s portfolio to private credit alongside traditional equity and bond index funds.
Private credit offers diversification benefits that can help stabilize portfolios during market turbulence. By blending private credit with a broadly indexed strategy, investors can capture the growth potential of equity markets while mitigating their downside risk through the steady income stream provided by private credit.
As investors find this balance, it’s important to be mindful of the vintage effect. Funds from 2020 and 2021, established during a period of low interest rates, may struggle as companies now face higher-than-expected interest expenses. For investors holding these older vintages, it may be wise to reallocate to newer funds better suited to the current rate environment.
Investors who are considering private credit investments should start by assessing their overall portfolio strategy. Determine what percentage of the portfolio to allocate to private credit, keeping in mind its role as a diversifier rather than a primary driver of returns.
Complexity can build quickly in alternative markets, so investors should consider working with a financial advisor who has experience with private credit. They can help determine adequate risk profiles and identify fitting credits to invest in.
Positioning For Long-Term Success
Investors’ ability to select high-quality credits and manage risk is key to success in this space. When compared to the high-yield market, default rates of private credit are considerably lower and recovery rates are significantly higher. However, defaults in the leveraged finance market still pose a significant threat to performance.
Given that private credit investments are typically illiquid, getting these decisions right from the outset is crucial. Unlike liquid credit, where investors can quickly exit risky positions, private credit requires a long-term commitment. This makes the initial credit selection process all the more important as it determines the overall risk profile and potential returns of the investment.
Risks are ever-present. Still, I believe those who can integrate private credit into their portfolios will be better positioned to capitalize on the opportunities ahead. The combination of broad market exposure through indexing and the volatility-averse yields available in private credit offers a strategy for long-term success.
The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
Forbes Finance Council is an invitation-only organization for executives in successful accounting, financial planning and wealth management firms. Do I qualify?
