If it provided nothing else the great financial collapse of 2007 – 2008 provided an important lesson in the diversification within investment portfolios, especially an allocation strategy that incorporates non-correlated asset classes, such as investing in hard assets. Following the rebound of the financial markets from the Great Recession up through the current market highs, modern institutional investors are in an undesirable position: they must choose between staying the course in equities showing peak measures or readjust their portfolios into low-yield but stable fixed income environments.
Over the past several years a broad swath of alternative investment strategies, including commodities, managed futures, and private equity, have all had their fifteen minutes of fame. However, one very attractive option for diversification has yet to receive the credit it is due, private credit.
There are several reasons this is an ideal time for institutional investors to add private credit to their investment portfolios:
- The primary reason is that current interest rates and credit spreads are hovering near rock-bottom with little to no indication that relief is coming soon. Many investors find the yields in the U.S. government credit markets unacceptably low, with foreign sovereign debt even less appealing.
- A second consideration is that current private credit valuations across traditional asset classes are extraordinarily inflated above what most prudent investors would consider reasonable. For example, as of last June Berkshire Hathaway, Inc. has an enormous amount of cash on hand because it could not find a single entity worth buying.
- Lastly, increased credit risk for higher yield for investment-grade corporate debt is not being adequately compensated. Traditionally moving down the curve and taking on riskier debt gave a higher yield, but the current return of approximately 6% is less than appealing.
There are a few segments of the private credit market that offer high credit quality and improved returns. Bank loans typically stand at the top of the borrower’s credit structure and can offer attractive returns relative to the associated risks. In addition, well-chosen, extremely short-term corporate accounts receivable can involve very low default risk. Even though this risk is traditionally accessed through the commercial paper market, new origination channels are emerging that provide higher yields.