Private credit strategies are delivering returns far ahead of public bonds, which should prompt institutional investors to rethink the way they allocate their portfolios.
Research by Cambridge Associates found that, in the year to 30 September 2018, private credit funds returned an average of 10.3 percent across all strategies. By comparison, the Bloomberg Barclays Government/Credit Bond Index saw returns of -1.37 percent over the same period, meaning private debt returns are currently in a completely different ballpark.
Tod Trabocco, managing director at Cambridge Associates, says the huge gulf in performance between bonds and private credit has been driven by particularly difficult conditions in bond markets.
“We’ve been in a bull market for bonds for a long time,” he explains, “the macro economics, with low interest rates, reductions in quantitative easing globally, it’s creating a very bad environment for bonds.”
As an average 10.3 percent seems high, but one would expect that in an asset class as diverse as private debt that average could be skewed by some of the higher-yielding strategies falling under the private debt umbrella. Senior debt should deliver a relatively low-risk and low-return investment, while mezzanine, distressed or niche asset classes like aircraft leasing would be expected to deliver much higher returns, approaching equity levels.
Respect your senior
However, Trabocco says senior debt returns are actually much higher than many expect: “Senior debt funds can often return 10 percent to 12 percent if they’re levered, while unlevered senior debt can return 6 percent to 8 percent.”
This means the average return is supported by a core of senior debt investment which is much lower on the risk spectrum and explains the relative stability of returns that Cambridge Associates has recorded over the past two decades. Over the last five years, average returns were 8.75 percent per annum, and over 20 years they reach 10.42 percent per annum.
With such a wide return disparity between public bonds and private credit, the question arises of why investors would not be shifting their fixed income allocations into private debt, but Trabocco says there are many barriers for institutions.
“Investors want liquidity and they value it,” he explains, “the other problem is many institutions lack the mandate or flexibility to move their existing bond allocations into private credit.”
However, he says investors which cannot invest in private debt from their fixed income pools may benefit from allocating capital from their alternatives sleeves. Hedge fund performance has been weak recently and is an obvious area which could be reallocated. However, Trabocco believes there could also be a case for reallocating private equity money as well.
“We’re doing some research right now on the differences between private credit and private equity returns and the extent to which they deviate and private credit returns are surprisingly close to private equity,” he says.
According to Cambridge Associates’ early research, private credit has returned an annual average of about 12 percent since 1988 with a standard deviation of 14 percent. Private equity returns are also approximately 12 percent, but with a 19 percent deviation. This poses some serious questions for investors.
While private equity can deliver significant outsized returns in good years, and some private equity managers have much better track record performance than the average, for those institutions holding private equity investments providing underwhelming performance it might make sense to reallocate some of their private equity pool into private credit. They could see very similar rates of return with dependable yields, a lower rate of deviation and a better risk-return profile.