Private debt offers an attractive alternative for fixed income investors

The fixed income asset class is structurally unattractive. We have been living in a low-yield environment for many years due to massive money printing by major central banks. And even though long-term yields have rebounded recently, there are still about USD 13 trillion invested in bonds with negative yields. What is more, less than 10% of the global bond market offers a yield above 3%. Investors that require higher returns need to focus on the riskiest parts of the bond market. The problem is that even high-yield bonds don’t really compensate for the additional risk. Credit spreads are tight. US high yield spreads, for example, are at the lowest level since 2007, before the Great Financial Crisis.

Given the lack of returns in traditional fixed income, conservative investors might be tempted to take on more risk by increasing their equity exposure. It is tempting, for example, to move from a conservative 40/60 to a more aggressive 60/40, or 80/20 portfolio.

Historically, equities have achieved annual returns close to 7%, which appears relatively attractive. However, investors need to be able to stomach the much higher volatility, with an annual standard deviation close to 20%. While the current outlook appears favorable, there is always a risk of bad timing. Sometimes it takes many years to recover from a drawdown, and the biggest drawdowns are typically caused by unknown uncertainties or completely unexpected shocks. Therefore, a positive outlook alone should not alter the personal risk profile. Asset allocation should be based on personal goals and needs, rather than macroeconomic views. Currently, the stock market outlook depends mainly on the success of vaccination roll-outs, the resistance of new SARS-CoV-2 mutations, political risks and economic variables such as job creations, consumer spending and inflation.

However, investors don’t necessarily need to increase risk to achieve higher returns. There are attractive fixed income alternatives in the private debt area.

Private debt is still a relatively new asset class, and thus not fully understood. Private debt, or private lending, typically refers as loans made by any parties other than banks, credit unions and government entities. Investors can get access via specialized asset managers or, though less recommendable, via online lending platforms. In our view, the most attractive area for conservative investors is the Senior-Secured Direct Lending strategy. It refers to direct loans that are not only senior in the balance sheet structure of the borrower, but also come with additional guarantees and hard asset collaterals, such as real estate. The seniority and high level of protection explains why the Senior-Secured Direct Lending strategy has much lower annual loss rates compared to senior loans or high yield bonds. According to data compiled by Blackstone, the average realized loss is only 0.3% per year, which is much lower compared to high yield bonds (1.7%) or senior loans (1.1%). 

Despite the lower risk, direct lending strategies offer attractive yields. Currently, investors get a yield pick-up of more than 4% compared to high yield bonds. This can be explained by the illiquidity premium and the scarcity of funding in the middle market. Most of the direct lending activity is for small and medium-sized businesses that are not only too small to issue bonds in the public market, but also increasingly struggle to get funding from traditional banks. The reason is that many banks have retreated from niche areas after the Great Financial Crisis due to new regulations, higher costs of capital and compliance. Many banks have pulled out of many niches due to new regulations. The scarcity of capital means that smaller companies are often willing to pay higher rates and offer stronger collaterals to secure funding from private debt funds.

Investors can benefit from higher returns and strong protection by investing in private debt funds. Strategies in conservative areas, such as Senior-Secured Direct Lending offer the best alternative to traditional fixed income securities. The strategy offers returns of 6 to 10% without leverage. Katch focuses on short-term opportunities, where capital supply is even scarcer with almost no competition from other lenders. What is more, the short-term focus helps to mitigate the illiquidity risk. Investors can pocket the illiquidity premium without sacrificing liquidity, because short-term lending funds typically offer monthly or quarterly liquidity to investors.

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