If 2022 taught us anything, it’s that “safe” assets may not be quite as safe as we thought.
For many investors, bonds have been the common tool to balance risk in portfolios. And yet, one of the most widely watched bond indices, the Bloomberg Global Aggregate Bond Index, was down 16% by the end of the year.
A negative 16% return in an asset class commonly used to balance portfolios is a tricky position for long-term investors. While we don’t think investors should throw out portfolio construction principles, it poses serious questions for those relying on the typically negative correlation between debt and equities.
At Nest we are focusing on how credit markets may develop, particularly the uncertainty over where inflation and interest rates will ultimately settle over the medium term.
Inflation has remained persistently high around the world, and central banks have responded by increasing interest rates at a rapid pace and undertaking quantitative tightening.
The impact of higher interest rates and slowing economic growth are giving investors pause for thought. The era of easily available credit, with ultra-low interest rates, appears to be over for now.
Defaults should be the big concern for credit investors. Warren Buffet famously once said: “When the tide goes out you get to see who was swimming naked.” Due diligence is key, and investors will find out in the coming year whether they have been thorough.
Suppressed yields on sovereign and highly rated bonds have encouraged investors to explore riskier and higher yielding asset classes to boost returns and try to meet investment targets. These have been enticing options, more so because average default rates in recent years have been low by historical standards.
For example, default rates in high-yield bonds are around 1% versus a long-term average more like 3.5%. It’s a straightforward conclusion to expect default rates will increase from these low levels given a challenging economic backdrop.
Companies warned about revenues throughout 2022, saying high inflation will eat into households’ budgets and lower sales. Many start-ups and smaller, newer companies have also only experienced credit markets where they can access funding easily and at low costs.
The new landscape, with the ‘end of free money’, presents a fresh challenge.
There are ways to mitigate risks in the credit space. For a start, lending through private credit can offer greater reassurance than their public counterparts and historically, private credit has generated excess returns compared with public debt instruments.
Default rates have traditionally been lower in private markets and recovery rates on defaulted debt are typically higher1. Currently we are not seeing a significant rise in defaults but that could change.
Lenders in the private space may feel more reassured given the potential for negotiating protections into terms, and the ability to directly interact with companies that may be struggling.
Private lenders can also be compensated for taking on illiquidity risk. The illiquidity premium does not always exist though, as public bond spreads react much faster to changing sentiment and conditions. Investors need to be mindful of market pricing and whether they are being adequately compensated for the risk.
With borrowing becoming more expensive, liquidity concerns should only push up the premium investors can access. As the yields on government bonds have risen, investors will require a higher interest rate on corporate debt and a sufficient illiquidity premium on top for private corporate debt.
At Nest, some of our members will be investing for 40-plus years. That gives us something we can leverage in helping boost their returns.
What’s more, the use of floating rate instruments in direct private credit loans means investors can receive higher absolute returns as interest rates rise.
This is an opportunity to protect the lender when inflation is so high. Existing public bonds with fixed rates will be hurt by falling prices as yields rise.
Whilst floating rate notes means that corporates will face these higher costs immediately, if chosen carefully, direct lending offers a lucrative opportunity as companies struggle to find credit elsewhere. It’s one of the reasons why private credit, or alternative lending, has expanded so much in the past two decades.
While I’ve focused on direct lending to companies, investors can also benefit from putting money into other private asset classes, such as infrastructure and real estate debt. There are many interesting options across the private credit market which may suit your risk profile more closely.
Portfolio diversification is about more than listed equities and bonds.
Notes
[1] Public versus private debt – what’s the difference? www.abrdn.com/en-us/institutional/insights-thinking-aloud/article-page/public-versus-private-debt-whats-the-difference
Craig Mitchell is the investment economist at Nest
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