SprottWealth Insights

The emergence of private debt

Click here to download a free copy of SprottWealth’s Private Debt Reference Guide.

Central bank policy interest rates in Canada and the United States continue to hover near the zero-bound as year-end approaches. Markets are pricing in a high probability of a rate hike at the Fed’s December meeting.

However, any change would be small, and the US central bank’s so-called dot plot suggests that rate hikes are unlikely to be significant during the coming year. The result has been continued interest by yield-hungry investors in a wide range of alternative asset classes, one of which is private debt.

According to this year’s Preqin Global Private Debt Report, private debt investment has shot up more than three-fold during the past decade, from $150 billion in 2006, to $561 billion by 2016. Part of the reason for the category’s success is that the growing supply of investors has coincided with strong demand from an increasing number of creditworthy mid-market companies.

Solid risk-adjusted returns; less volatility

That is in part due to the fact that regulatory reforms enacted following the 2008 financial crisis tightened banks’ capital requirements and simultaneously reduced their lending capacity. As a result, many mid-market players who needed access to factoring, asset-based or short-term loans had to look elsewhere and pay higher rates of interest to obtain financing.

That’s good news for investors in the private debt category, which has performed well over time. According to TIAA Global Asset Management, mid-market loan returns averaged 6.2% between 1999 and 2015. That compares with 6.3% for high-yield bonds, 5.6% for corporate bonds, 5.0% for the S&P 500, and 4.2% for 10-year Treasuries.

As if that were not enough, private debt investment returns have low levels of correlation with other major asset classes. Low correlation is important because it provides your portfolio with the “holy grail” of outcomes: better diversification. And according to a Capital Group report, private debt is considerably less volatile than key fixed-income benchmarks and equity indexes[1].

Accessing through funds

The two big challenges that private debt investors face are the research time required to source and make investments, coupled with the need to broadly diversify holdings among several players. Channeling investments through credit trusts and similar fund options, has thus long been a preferred option.

That said, private debt is not for everyone. Although risk adjusted returns have been good, private investments can be complex and less transparent than investments in traditional securities. As such, they are currently only available to accredited retail investors, who need to make sure that they get solid professional advice, before dipping their toes in.

Continued growth potential

Those who take the time to learn about the category will have access to a promising tool. Private debt investments appear to continue to have legs. The Preqin study cited above found that 92% of institutional investors intend to maintain or increase their allocation to the category.

Secular and economic monetary policy developments also look favorable. Rates on public and (some) corporate debt have fallen below zero in Japan and many European countries. Elsewhere, in Brazil and India, nominal rates are higher, but high inflation levels leave real rates deep in negative territory. These trends, if they persist, will inevitably provide continued downside pressure on North American central bank yields.

Although the relationship between central bank actions and bond yields is complex, financial institutions will almost certainly continue to feel the heat. If banks don’t have the room to charge the risk premiums they need to cover potential loan losses, they will continue to transfer their limited capital resources into non-lending investments. That in turn would open new opportunities for private debt asset managers.

In that environment, yield starved pension funds, insurance companies, institutional investors, and Canadians counting on generating income from their accumulated savings to fund their retirements, are going to be increasingly attracted by this growing investment option.

Ask your advisor how you can access Private Debt strategies in a way that can help you meet your financial objectives.

 

1 See SprottWealth Private Debt Reference Guide