Updated: Jul 19, 2021
How are big pension plans responding to low interest rates?
Brendan Greenwood CIM, QAFP, B.Comm | July 14, 2021
This is a difficult time for investors who have relied upon the stable return of bonds to anchor their investment portfolio. Current interest rates are very low adding to the potential for negative bond returns with any increase in interest rates. Canadian investment-grade corporate fixed income securities have lost over 2.12% so far this year (Canadian Fixed Income Indexes (ftserussell.com)). This is a real challenge for many investors with balanced portfolio mandates who have relied upon the tradition 60% equity 40% fixed income mix.
Professional money managers recognize that traditional bonds in the current low interest rate environment are a less stabilizing force than they once were and do not provide the yield most investors require if they have retirement or other income needs. Some of the biggest pension plans in the country have begun to respond. Individual investors should take note and re-evaluate how their own portfolios are positioned.
Let’s look at how one of the world’s biggest pension plans, the Canada Pension Plan (CPP) has positioned their portfolio to address the need for yield and stability in today’s historically low interest rate environment. The visual below taken from the Canadian Pension Plan Investment Board (CPPIB) annual report displays fixed income representing only 10% of the portfolio with real estate, infrastructure and private credit making up most of the difference. I have written about the potential of infrastructure and real estate as attractive diversifying alternatives to bonds with higher rates of return.
In this article I would like to review the merits of having a portion of your portfolio invested in private credit. CPPIB is just one of many top institutional investors that allocate significant money towards private credit to provide enhanced yield, improved credit quality and increased diversification.
What is Private Credit and How Can it Benefit Your Personal Investment Portfolio
It is difficult for many mid-size companies to obtain financing from banks for purposes such as re-financing, acquisitions or buying a family members stake of a business. In most circumstances the public markets are not accessible for these businesses because of their size, the costs involved, and significant regulatory burden. Private credit is a way for these enterprises to access money efficiently through a single loan agreement with one counterparty. They are often able to negotiate flexible repayment terms that can be adapted to the business’s unique cashflow profile. The single debt instrument also allows these businesses to reduce their legal and administrative costs.
Let’s explore why private credit can help manage risk in your investment portfolio while providing you with more investment income:
Private credit typically is a direct loan between the lender and the borrower. Unlike broadly syndicated loans, private credit does not change hands multiple times in the market. This means the private credit issuer has much more control over the terms of the lending. A well managed private credit portfolio will have the majority of their loan book allocated to first lien loans where they are the first to be paid if a borrower defaults.
Private credit is more often better credit quality than high yield bonds that can be bought on the public market. High Yield Bonds are often issued by financially struggling companies that have a higher risk of not making all interest payments or defaulting on the repayment of principal. The chart below compares the credit loss rates among different debt investment options.
2) Protection from interest rate risk
Private credit loans are usually structured so the interest rate paid by the borrower is tied to short term interest rates. If interest rates rise the lender earns a higher return. This provides an advantage over fixed rate bonds that are more vulnerable to a sudden change in interest rates that would cause the value of the bonds to fall.
Investments in private credit are less correlated to the public market and can provide cashflow stability.
4) Higher yield
Private credit issued to mid-market companies in North America and Europe often provides investors with yields of 6 to 8%. The chart below displays the credit spread between different debt investments.
The yield premium offered by senior mid-market direct lending (private credit) stems from a number of factors:
· Size of the transaction
· Flexibility of repayment terms
· Complexity of transaction
· Ability of investment manager to source an attractive deal
There is also often an illiquidity premium, because unlike publicly traded bonds for example, these loan issues cannot be traded in and out of day to day, although certain private credit issuers offer more liquidity than others.
Some private credit funds have access to extensive financing facilities that can be used to apply leverage to more senior loans with better credit quality increasing the overall yield of the fund.
Private credit is more accessible for individual investors than it has been in the past and provides the potential for attractive yield while serving to reduce the overall risk to your investment portfolio. With traditional bonds offering little yield and the public stock market being far from cheap, trading at historically high valuations, there has never been a better time to explore allocating a portion of your investments to the growing space of private credit. Private credit funds are accessible through an investment advisor for individual investors who qualify.
Brendan Greenwood is an Investment Advisor with Worldsource Securities focused on personal pension strategies and leveraging technology to provide progressive institutional style investment solutions for professionals, incorporated individuals, business owners, retirees and their families.
For other articles authored by Brendan Greenwood on issues impacting business owners and individual investors see https://www.greenwoodwealth.co/blog.
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