Industry voices

Higher yields, without increased risk

Private credit in many ways is the fixed income analog to private equity

Andrew H. Plevin
Andrew H. Plevin, co-CEO BroadRiver Asset Management LP

In the rebound of the financial markets from the great financial collapse of 2007-'08 to recent highs, today's institutional investment managers are now in an unenviable position: remain invested in equities that are at peak historical measures of value or rebalance their portfolios into low yielding fixed income. Facing a continuation of a yield-starved, low-interest-rate environment, traditional fixed-income investments no longer deliver sufficient yield along with the predictability and stability institutions require, making any reallocation choice especially painful.

If nothing else, the financial crisis drove home the importance of diversification within investment portfolios, especially an allocation strategy that incorporates non-correlated asset classes. Over the past few years, a wide range of alternative investment strategies, including those structured around commodities, managed futures and private equity, have come to the fore. While many of these strategies have a place within a diversified investment portfolio, an option that has not received the attention it deserves is private credit.

There are several reasons this is an ideal time for institutional investors to add private credit to their investment portfolios. First, interest rates and credit spreads are at or near bottom with little indication that relief is on its way. Many investors find the yields in the U.S. government credit markets unacceptably low, with foreign sovereign debt even less appealing.

A second reason to consider private credit is that current valuations across most traditional asset classes are inflated beyond what many prudent investors would consider reasonable. For instance, as of late June, Berkshire Hathaway Inc. had more than $50 billion in cash on hand, as the legendary value investor couldn't find anything worth buying.

Traditionally, an investor looking to boost yield in the fixed-income space would move down the credit curve and load up on risk as a trade-off for higher yield. That simply does not work anymore: Increased credit risk is not being adequately compensated by acceptable yield. Current yields on investment-grade corporate debt generally are less than 3%, with high-yield debt trading at less than 6%. Those are unappealing options, particularly when combined with the recent erosion of debtor covenants and other lender protections.

Frontier efficiency

Private credit is a relatively new term, encompassing a variety of strategies that take advantage of changes in borrowing, lending and other forms of finance. It has in many ways become the credit analog to private equity.

Among the advantages that the private credit space brings to investors is the ability to fine-tune yield seeking and risk selection with more flexibility than can be achieved in the traditional fixed-income world. With private credit investments, institutions can insist on a senior position relative to other creditors, duration that more closely matches their liabilities and lower correlation to the credit markets generally. Many institutions see this ability to select assets and manage risk as a better outcome than what is available in the public fixed-income world.

At the same time, private credit shares with private equity the characteristic that returns can only be achieved by holding assets until maturity — or at least until they ripen. This usually results in reduced liquidity, but the investor can be more than rewarded in higher return and lower portfolio volatility.

Not all private credit strategies are the same. Some deliver a current yield and are non-correlated, and others have much greater correlation. Some self-amortize in the short term, others require a longer harvesting period. Some are clearly not prudent for institutional investors with persistent liability obligations. For these investors, fixed-income assets must deliver reliable cash flow and low-volatility returns, not simply mark-to-market gains.

One of the important features for any institutional investor to consider when choosing a fixed-income investment — including private credit — is where that obligation lies in the obligor's credit structure. Just like in public forms of fixed income, the obligation can be at the senior level or a very junior, unsecured position. The preferred strategies are those at the senior credit level, highly collateralized where credit risk is low.

A second important feature for pension plans and endowments is the self-amortizing feature of a particular private credit strategy. Strategies and asset classes that deliver reliable and relatively continuous cash flow permit managers of pension plans and endowments to match their private credit investments to their spending obligations. For them, strategies with smooth and predictable cash flow are preferable to those with lumpier and less certain distributions.

As with any asset class, there is a range of vehicles and strategies for investing in private credit, each with its own strengths, weaknesses and degree of appropriateness. One strategy attracting media attention is peer-to-peer lending. In our view, this is the least interesting attractive private credit strategy for institutional investors. More sophisticated opportunities — such as bank loans, direct loans to midsize corporations, short-term corporate receivables, life settlements and municipal tax receivables — offer more interesting possibilities.

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 risks. In addition, well-chosen, extremely short-term corporate accounts receivable can involve very low default risk. Although this risk is traditionally accessed through the commercial paper market, new origination channels are emerging that provide higher yields.

Two areas that combine high credit quality, compelling yield and low correlation are municipal tax receivables and longevity assets. With municipal tax receivables, the institutional investor has a senior position relative to any mortgage lender and tremendous collateral coverage, because it has the right to take possession of the property with clear title if the obligation is not paid on time and the amount invested is typically only a small percentage of the value of the property. Longevity assets involve pooled life insurance policies, which are protected by the tremendous reserves of the insurance carriers. Even during the financial crisis no major American life insurance company lost its investment grade rating, which says a lot about the creditworthiness of these types of assets.

If they aren't doing it already, private credit is an area where institutional investors need to be active. It's important for pension plans and endowments to maintain a position in fixed income as a way to keep balance in their portfolios. With yields on the public side of fixed income expected to remain low, private credit can offer an important substitute.

Andrew H. Plevin is co-CEO and founding principal of BroadRiver Asset Management LP, a New York-based firm specializing in the management of fixed-income alternative investments, including private credit.