Allocating to private credit in a portfolio

Victoria Quach: That’s a really helpful way to break it down. Broadly speaking, we see private credit as an extension of fixed income, which embraces a more flexible approach to fixed income investment. And remember, at Capital Group we believe fixed income has four key roles in a portfolio: preservation, inflation protection, income and diversification, broadly meaning diversification from equities.

What is private credit’s role in a portfolio?

Private credit doesn’t check all four boxes, but it checks two of them very well. The one that jumps out right away in private credit is income. On average, recent returns show that private credit can provide 3% excess yield relative to high-yield bonds. Our analysis is that private credit has been a stable, consistent source of income generation. The excess yield isn’t free: It’s compensation for the illiquidity risk an investor takes, among other factors. This is considered an illiquid asset class.

A different kind of diversification

Victoria: The second area of benefit we see is diversification. When we talk about diversification as a role for fixed income, what we mean is diversification from equities, so that if the equities markets weaken, the fixed income in your portfolio has some ability to offset that. But when we talk about diversification as a role for private credit, it’s slightly different  — it’s diversification because you’re gaining exposure to a different set of companies than you would in public corporate credit. You’re getting exposure to middle market companies, often private companies, certainly companies that are less common in public markets. And beyond exposure to a different kind of company, you’re getting exposure to a different structure of loan, which we see as another kind of diversification. For instance, another area of private credit where non-corporate loans are backed by two forms of collateral, (1) pools of credit receivable assets like mortgages and auto loans or (2) specific assets like aircraft, leasing equipment and even music royalties can have cashflow profiles that are distinct from corporate lending. 

Victoria: If you want to go back to that original fixed income goal of diversification from equities, you can get that too in private credit. If we lean on the traditional measures of diversification in a portfolio, which is correlation, we find that private credit has less correlation to U.S. equities compared to high yield bonds. About 66% historically, whereas high yield bonds have had historically about 86% correlation to U.S. equities. I should note, for a lot of this comparative data we’re using a direct lending index, and that’s what’s available to us from an index-based analysis. So a lot of when we reference the historic performance of private credit, it is the direct lending component.

Why is the yield higher for private credit?

Jan: Can you go a little deeper on incremental yield, where is it coming from? Or to put it another way, why is the yield higher?

Victoria: That’s a great question Jan. And when we think about yield, a meaningful component of the total return for private credit, ultimately what that is, is an investor’s compensation for taking on some kind of risk exposure. For private credit, it’s a mix of largely taking on credit risk and the relatively illiquid nature of the asset class. If we start with the illiquidity premium, it’s not just the fact that these loans aren’t traded easily  — there’s no secondary market for them  — it goes beyond that. The illiquidity premium includes the bespoke, complex structures and the lower level of transparency associated with these types of bonds. And because you’re taking on that risk exposure, you should be compensated for it. In addition, for investors with excess liquidity capacity, investments that offer an illiquidity premium can serve as a way to potentially monetize that surplus.

The illiquidity premium along with unrated credit requires greater expertise to evaluate these types of loans. That investment manager expertise is an important consideration for investors.

Now, let’s dive a little deeper into the credit premium, the compensation investors expect for taking on credit risk. For direct lending specifically, there’s typically no coverage for these types of loans by the credit rating agencies. So who takes on that role here? The role is taken on by the active manager. They are evaluating the credit-worthiness of these borrowers, which can depend on the borrower’s operating cashflows. These types of loans tend to be senior secured loans, at least for direct lending. When we say senior, we mean senior in the capital structure, which means that in the event of a default, these investors are prioritized in the repayment. Whereas typically with public high yield, it’s subordinated, or junior debt, which is lower in the capital structure. And finally, by secured, we mean that they are backed by some sort of collateral, which can include a wide range of assets such as real estate, inventory, etc. Overall, I think the important point here is that the credit premium has different features between public and private credit.

Key question: How much to allocate to private credit?

Victoria: And when an advisor or investor gets to that question of how much of my portfolio should I allocate to private credit, we start where we always start at Capital Group with the questions, “What are the overall objectives of the portfolio? And how do we align asset classes and funds to achieve those objectives?”

Jan: It seems that this is where investors really have to address liquidity issues, and their comfort level with an investment that is not going to be as liquid as public market investments.

Victoria: Absolutely. This issue of how much to allocate to illiquid investments can be a complicated issue, but you can boil it down to three factors. It’s a combination of the investors’ capacity for risk, cash flow needs and time horizon. I think this is somewhat intuitive: The lower the risk capacity and the higher the cash flow needs, the lower an allocation you would make to less liquid investments.

We’ve developed a framework to get us to some answers. It starts with some questions: what is your annual spending rate and what is your time horizon? So let’s assume with a spending rate of four percent and a five-year time horizon. We take those variables and apply them to a hypothetical portfolio consisting of public fixed income, global equities and varying amounts of private equity, private credit and private real estate and then we ran 5,000 simulations over a five-year period.

From those simulations, we found that you can allocate up to 65% in semi-liquid investments and still potentially achieve the 4% spending rate in every period across the five-year period. We believe this is a conservative view, that there’s a high probability you will achieve your spending rate. But this is important, we’re not saying that your optimal allocation to semi-liquid investments is, in this case, 65%. What we are saying is that you can allocate, hypothetically, up to 65% and potentially achieve that annual 4% spend rate. I think this is really powerful, so that investors can understand what that zone of feasibility is and how they should think about allocating to semi-liquid investments. Spoiler alert: We would recommend a considerably lower allocation to private credit, but what we’re establishing here is that you can have a relatively high allocation and still meet annual spending needs.

Jan: And so, this directly addresses concerns about illiquidity being a reason not to invest. If the client needs lump sum access to a lot of money, yes liquidity is a concern. But what you’re showing us here is that the normal level of access of 4% is not impeded by a semi-liquid solution. And to your point we’re not saying, “allocate 65%.” But I think it’s making the point that, for a normal use of your money, the semi-liquid nature should not be a deal-breaker. That’s relevant because I do think the illiquidity of this asset class is what people remember.

So now we’ve positioned the role in the portfolio, we’ve talked about liquidity, are we ready to answer the question, “How would I allocate to this?” Can you talk through some of that allocation guidance?

How might I think about allocating to private credit?

Sample paper portfolios with more aggressive use cases

Victoria: So then if we dive into the first set of paper portfolios, here we are aligning it to an aggressive credit strategy. The commonality across these three profiles is a higher tolerance for risk. And then as we get toward an even more conservative profile, which is a 50-50 allocation as the starting point, seeking income is a prioritized portfolio objective. Because you have that need for potentially higher income, we think a strategy that includes private credit could be additive to the portfolio. And overall, where could you be funding it? The natural starting point would be other credit-sensitive strategies in the portfolio. So it likely comes out of your overall fixed income allocation, and then within that fixed income allocation, it comes out of more credit-oriented strategies.

Even a small allocation we think has the potential to change the overall risk/return profile. So, for instance, in the 80-20 portfolio, we allocate a modest 5% to this semi-liquid credit strategy. And the reason for that is, it might seem like 5% is very small. But equity risk dominates that overall portfolio’s risk. And because credit tends to be positively correlated with equities, we think that you may want modest exposure here.

Jan: I think it makes a lot of sense, and I like the idea of using time horizon as a crucial factor, because it really gets at that question of capacity to handle illiquidity. Can you take us through the same process with a more conservative use case?

How can private credit fit in a portfolio?

Sample paper portfolios with more conservative use cases

Victoria: Of course. Quite naturally, it should be a lower risk profile for the credit strategy, and that’s what we’re demonstrating here. So we started with the traditional 50-50 portfolio and allocated about 15% from the fixed income exposure to this hypothetical semi-liquid fixed income exposure. The reason for this is, this 50-50, we thought the persona would be a conservative growth and income investor. Because they have that need for income, they want to stay relatively conservative and have a more stable overall total return profile. Similarly, for the 30-70, which is even more conservative, we reduced that allocation to the fixed income strategy that includes private credit. The key here is, especially as you move into the more conservative profiles, we think that it’s really important you need to maintain that low to moderate liquidity need.

Jan: Thanks Victoria. We’ve covered a lot of ground and I hope we have answered a lot of questions. To recap, depending on a client’s specific objectives, time horizon and comfort with illiquidity, private credit can be a valuable addition to a portfolio, offering incremental yield and diversification  — even at modest allocation levels of 5%. Private credit can also help complement traditional public stock and bond holdings by providing access to a broader set of companies and loan structures not typically available in public fixed income markets.

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