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Private credit offers an escape from miserly bond yields

Private credit offers an escape from miserly bond yields

Let’s begin with the bad news. For reasons that are quite clear if you follow my writings on a regular basis, equities and bonds will most likely deliver disappointing returns for many years to come.  

My central forecast is an annual average inflation-adjusted return of 0-2% on a global portfolio consisting of 40% bonds and 60% equities between now and 2050.

The good news next.  Fortunately, there are many things you can do to improve on those lacklustre numbers. Those returns are for the lazy investor; someone who invests passively. 

Today, I will review one of the ‘escape routes’, should you desire higher returns - an investment strategy I call private credit.

Private credit, as opposed to public credit, includes all non-public transactions conducted away from banks, where one party owes a sum of money to another party, be it lending, leasing, royalties or otherwise. 

If you buy a listed bond (i.e. public credit), you can redeem from the investment overnight.  That is not possible in private credit, and that is the most noticeable difference between the two.

Depending on your appetite for illiquidity, (expected) returns vary a great deal.  At the quasi-liquid end, where you can redeem quarterly, returns may (on average) be hovering around 5%. 

At the illiquid end, where your capital is tied up for, say, five to seven years, 7-8% annual returns are perfectly normal.

I am aware that you might get the occasional email, ‘promising’ you 20% or even higher returns on for example peer-to-peer lending, but I will exclude those offerings in this context, as I want to compare apples to apples (i.e. private lending to corporate bonds or bank lending). 

Given the returns on offer in most bond markets these days, even if you don’t want to go too far out the illiquidity curve, returns on private credit are still attractive.

Within private credit, Direct Lending is undoubtedly the sub-strategy that has attracted the most capital from investors in recent years (see chart below, courtesy of data provider Preqin).

Returns generated by direct lending funds vary quite a bit depending (amongst other things) on the credit rating of the borrowers, the seniority of the underlying loans and the use of leverage by the investment manager in question, but mid-to-high single digit returns are quite common.

Trade finance is another private credit strategy that has grown massively more recently. 

Before 2008, commercial banks had virtual exclusivity on this market, but the rising bureaucracy in banks has moved a substantial part of it into the hands of alternative lenders. 

If the manager of a banana plantation in Zambia wants to secure export finance for a shipment of bananas to the UK, he can hardly wait two to three months for his bank to approve the credit application, can he?

Trade finance can be either import or export related, and there is almost always an emerging market domiciled company on at least one side of the equation.  Returns vary depending on region (mostly Africa, Asia or South America) but are typically in the 5-10% range. 

The risk is relatively low, and liquidity terms usually amongst the best in the private credit space, as the financing is mostly short-term in nature.

These are just two examples picked from a rapidly growing universe of private credit strategies. Should you want to learn more, the September issue of the Absolute Return Letter, which you will be able to find at the above link from Monday the 3rd September, will contain much more information on this opportunity set.

Niels Clemen Jensen is founder & chief investment officer at Absolute Return Partners and a Citywire Wealth Manager columnist. he is the author of the recently published The End of Indexing

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