Dinner party conversations II – Private Debt – What is it and should it be in my portfolio?

Chris Forrest- Sovereign Wealth Partners

Portfolio dinner party conversations

Guest 1: “My problem is my bond funds aren’t earning anything and term deposits aren’t any better. I need more income’”

Guest 2: “So what will you do?”

Guest 1: “My adviser just recommended stay in my bond funds because they match my risk profile. ”

Guest 2: “Even though you’re getting a negative return? Have you looked at private debt?”

Guest 1: “No. What’s that?”

Guest 2: “Well, let me tell you. My advisers at Sovereign Wealth Partners wrote this excellent piece giving a brief overview. I’ll send you the article.”

Bonds and private debt

The debt that most people will have in their portfolio is bonds and credit. In all likelihood this will be via a managed fund. When advisers talk about bonds, it usually means debt issued by government entities. When they talk about credit it means bonds issued by companies. Bonds, whoever the issuer, are a loan. Debt in the form of a bond can be easily priced and traded on public markets, much like shares and so it can fluctuate in value.

Private debt is not a bond. It is investing by lending directly to the borrower for an agreed rate of interest which may be fixed or floating. The adjective, “private”, simply refers to the fact it is not traded on public markets in the same way when used to describe private equity (which is investment in companies not traded on share markets). Importantly, it is not a descriptor of risk.

Private debt can be lower or higher risk depending on the extent to which it is secured on assets and the quality of the underlying borrower. If you are taking lower risk because it is more secure, you can expect a lower interest rate and the converse for higher risk. Risk can be determined by the type of security, the level of gearing against that security and, where there are multiple lenders, the seniority of one lender over another.

Should I keep some bonds?

This is one of many vexing questions arising from today’s financial markets. Bonds normally provide investors with stability, liquidity and income. For decades they have been a fantastic asset class for long term investors as interest rates gradually fell. This is because, all other things being equal, a fall in market interest rates pushes up the capital value of the underlying bond. Consider, however, that interest rates have been at all-time lows and are now on the rise. Now, many types of bonds have been reversing their capital gains. The Bloomberg AusBond Composite index returned -3.44% for the year ending 30 November 2021. With inflation running at around 3%, that means traditional bond investors have suffered a real return LOSS (a return after inflation) of well over 6%.

Looking forward, if central banks allow interest rates to rise quickly in response to rising inflation, we may see bonds lose more value.

However, one reason for holding bonds is to balance out equity risk and by this we mean the risk of an equity market sell-off. Traditional bonds can provide a useful cushion. Generally , when equity markets selloff, the cash must go somewhere and often goes into bonds, delivering a short term boost to bond investors. However, it cannot be said that this will always work, as was the case in early 1994 when bond and equity markets crashed at the same time..

How to access private debt

The practical way for most investors to access private debt is through a managed fund. It may be a retail or wholesale offering. Like every other type of investment there are both high quality and poor quality products on offer today. It is best to get advice before investing into private debt. And, of course, always read the Product Disclosure Statement.

The fund may be an unlisted managed investment or, in some cases, listed on the Australian Stock Exchange (ASX).

The rise of private debt

Private debt is not new but has grown as an investment opportunity since the Global Financial Crisis when regulations were put on banks limiting their capacity to lend to certain sectors. (Without going into detail, banks are required to hold higher levels of capital on their balance sheets for distinct types of lending activity, which rations their ability to lend to different sectors by making it expensive for them).

What are the risks?

That depends. You need to look at the fund in which you are investing to determine their strategy and associated risks. They may be directly lending to mid-market companies, distressed debt, infrastructure debt, real estate debt, mezzanine debt, special situations or venture debt. If the interest rate target looks high, the underlying loans may be riskier. Always take a close look at the strategy (and possibly loan book) to see if you are prepared to accept the associated risk.

One major risk of this type of investment is liquidity risk. Private debt is not liquid by definition. i.e. it is not bought and sold daily. This is one very big reason why it generates a higher yield than bonds – which is known as the “illiquidity premium”. There’s no reason why you as a long-term investor can’t benefit from the illiquidity premium, but you have to reconcile it with your own need for liquidity as an investor.

Liquidity to the investor in a private debt fund (the ability to get in or out at a fair price) depends on the product design and may be available monthly or perhaps longer. In the event of a market shock, default fears and investors rushing to sell, a fund may ‘lock-up’ i.e. not honour redemptions in the normal timeframe but hold off for months or potentially years until sufficient underlying loans mature. This does not make it a bad investment necessarily; it just means that your capital may well be locked up during highly stressed market conditions (and it may well turn out that it’s in your best interest to stay invested). Naturally the investor is beholden to the fund manager doing the right thing in these circumstances and having the experience and foresight to put the appropriate contingency plans in place.

When it comes to managing liquidity risk, quite simply, don’t over commit. If it’s the first investment you must sell to raise money, the initial decision to invest was a poor one.

What can I earn?

Again, it depends. You might see a product description something like this:

“Designed to deliver RBA cash rate plus 4% to 5%. Provides an inflation hedge as investments are floating rate. Predictable income stream. Low correlation to major asset classes”.

Back to the dinner party

Guest 1: “That was a terrific explanation. I need to take a closer look at that. Your advisers sound pretty good.”

Guest 2: “Yes they are. You should see them”.

Disclosure Statement: This communication has been approved and issued by Sovereign Wealth Partners Pty Ltd ABN 18 607 071 367 Corporate Authorised Representative (No. 001233909) of Sovereign Capital Pty Ltd ABN 44 164 127 833, AFSL 456235.

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