Accelerate Monthly -
Why Private Credit? The Rising Appeal for Diversified Investors
May 14, 2024 — The practice of lending goes back thousands of years, with loans representing one of humanity’s first investable asset classes, along with real estate (residential, farmland, and timber), precious metals (gold and silver), and art.
One of the earliest documented pieces of evidence of lending dates back to Mesopotamia around 3000 BC. Before fiat currency was widely utilized, the ancient society relied on barter, using food as a way to repay debts. For example, farmers would borrow seeds to plant early in the season and then share their crops to repay their debts after the fall harvest.
The practice of charging a set level of interest on loans was already established by the time of the First Dynasty of Babylon, notably under the reign of Hammurabi around 1800 BC. Under Hammurabi’s Code, one of the oldest translated writings of significant length in the world, laws pertaining to lending regulated the terms of loans, including the setting of interest rates and the pledging of collateral. Moreover, Hammurabi’s Code set specific interest rates, including a rate of 33% for grain, which was the principal form of currency at the time. The borrower would typically provide collateral, which the lender could seize if the loan was not repaid.
Furthermore, the practice of lending was generally accepted in ancient Greece, and it was socially acceptable for a lender, who risked their money or resources, to receive a profit in return. Interest rates were lower in ancient Greece than in Mesopotamia, with loans featuring interest rates generally between 12% and 18%.
Over the past five thousand years, the lending market has evolved significantly, particularly over the past four decades. Specifically, as the global economy and related capital markets have grown, credit markets have expanded markedly. However, the basic notion of lending, by allowing a third-party access to capital over a specified term and at a negotiated rate of interest, has remained constant.
As the capital markets have evolved, lending has split into two main segments:
- Bonds — A financial instrument that sits senior to the equity holders typically featuring a fixed rate of interest.
- Loans — A financial instrument that sits senior to the equity holders typically featuring a floating rate of interest.
The difference in these two income segments became particularly acute in 2022 when interest rates increased markedly. As interest rates rose that year, bonds got hit given their fixed rate of interest led to a reduced present value amidst higher rates. In contrast, due to their floating rate nature, loans generally outperformed bonds, given the yields tied to loans were adjusted upward as interest rates rose.
Historically, variable-rate loans were the business of banks, the main underwriters of variable-rate credit instruments. However, since the great financial crisis caused the banking industry to teeter on the brink, governments dramatically tightened bank regulations, causing large financial institutions to pull back from lending to private companies. Enter private credit.
Private credit refers to loans to private companies provided by non-bank institutions, most often an investment fund. This type of financing is typically used by smaller, middle-market companies, normally backed by private equity, that may not have access to public markets. Private credit arrangements are usually tailored to the borrower’s specific needs, offering more flexible terms than traditional bank loans. This sector has grown as investors seek alternatives to public bonds and equities, while the demand for variable-rate credit exposures has increased as interest rates have surged.
Generally, private credit is focused on senior secured lending with the highest repayment priority in the capital stack, leading to a lower-risk profile than equity or preferred shares given the higher repayment priority of senior secured debt.
Source: Accelerate
About three-quarters of the global private credit market is in the United States. The asset class has grown tremendously since 2008, increasing to $1.5 trillion, with assets under management expected to grow to $2.8 trillion by 2028.
The surge in demand for private credit in recent years is based on several factors, including higher yields, increased returns, and portfolio diversification.
Higher Yields
Private credit offers the highest yields compared to other large investable asset classes, including high yield bonds and preferred shares. The double-digit yields currently offered by private credit may be more attractive to income-seeking investors than traditional stocks and bonds whose yields are far lower. Currently, private credit yields 320bps more than high-yield bonds and 520bps more than preferred shares.
Source: JP Morgan, Accelerate
In a higher-for-longer interest rate environment, the high yields offered by private credit are expected to be sustained over the near to medium term. In addition, if interest rates rise, bond values will take a hit, while the floating rate loans of private credit may benefit from higher rates.
Increased Returns
Historically, private credit has provided differentiated returns for investors. For example, since 2000, the returns from private credit have compared favourably to other asset classes.
In addition, investors are attracted to the senior secured nature of private credit, providing a reliable income stream lower on the risk spectrum compared to equities or preferred shares.
Portfolio Diversification
2022 was a challenging year for the average investor, with both stocks and bonds dropping by double-digits. The rising rate environment blew a hole in the traditional 60/40 stock and bond portfolio, with the supposedly “safe” bond side of the portfolio shocking investors with a double-digit decline.
From the early 1980’s to the early 2020’s, there was a great bond bull market. The U.S. 10-year Treasury yield declined from a high of nearly 16% in 1981 to a low of 0.5% in 2020, buoying bond returns along with the 60/40 portfolio for decades. However, with interest rates normalizing, investors can no longer be comforted by steadily declining bond yields, which created a previous tailwind for bond investors. As interest rates have increased, bond investors have faced a headwind, while loan investors have had the winds in their sails given the rising rates tied to floating rate instruments.
Given their reliance on fixed-rate bonds, it turns out that income investors made a one-way bet on the direction of interest rates, and what worked for decades as rates declined stopped working as rates reversed. Floating rate exposures, via private credit, are now used by income investors to reduce their historically concentrated bet on the direction of interest rates.
The growth of private credit has allowed investors to participate in the double-digit yields offered by senior secured direct loans to U.S. private corporations, while also diversifying their income stream with floating rate interest rate exposures.
With the May 15th launch of the private credit ETF, the Accelerate Diversified Credit Income Fund (TSX: INCM), which will provide exposure to a portfolio of more than 4,000 loans (86% secured and 93% floating rate) with a forecast yield of 10% (paid monthly starting in June), investing in private credit has never been more accessible.
Accelerate manages five alternative ETFs, each with a specific mandate:
- Accelerate Arbitrage Fund (TSX: ARB): Merger Arbitrage
- Accelerate Absolute Return Fund (TSX: HDGE): Absolute Return
- Accelerate OneChoice Alternative Portfolio ETF (TSX: ONEC): Multi-strategy
- Accelerate Canadian Long Short Equity Fund (TSX: ATSX): Directional Long Short Equity
- Accelerate Diversified Credit Income Fund (TSX: INCM): Private Credit
Please see below for fund performance and manager commentary.
ARB declined by -0.2% in April, compared to the -0.9% drop for the S&P Merger Arbitrage Index.
While activity in the merger market was robust over the month, with 23 M&A deals announced in North America worth an aggregate of nearly $100 billion, spreads widened on regulatory concerns. The FTC moved to block the $8.5 billion merger of fashion brands Capri Holdings and Tapestry, despite the firms having a combined 5% of the global fashion market and obtaining clearances from all other global antitrust regulators, including China, Europe, Japan, and the United Kingdom. In any event, the Fund has a 0.9% position in Capri shares, which fell over the month. In addition, merger spreads generally widened on any deals in which merging parties are part of the same industry (basically most strategic (non-private equity) deals), given the increased regulatory concerns.
The SPAC market was slow in April, with no initial public offerings. Over the first four months of the year, there have been just six SPAC IPOs, which raised a total of $698 million.
ARB currently has 135.3% long and -8.2% short exposure (143.5% gross exposure), with 48% allocated to SPAC arbitrage and 52% allocated to merger arbitrage (with 22% in private equity buyouts).
HDGE produced a -1.4% return over the month, as North American long-short factor performance was mixed.
Specifically, the Canadian long-short factor portfolios were mostly negative, as each short factor portfolio was positive in April but gained more than the counteracting long factor portfolio. While the U.S factor portfolios exhibited positive performance in aggregate, both the underlying long and short portfolios declined markedly. While, the U.S. long factor portfolios fell between -5.0% and -6.0%, the corresponding short portfolios dropped between -6.8% and -10.0%. Ergo, the 110 long / 50 short structure of HDGE translated to a slight loss for the month, as the short portfolio declines were not substantial enough to offset the weakness in the long portfolio.
ONEC produced a flat monthly performance with asset class returns split down the middle. Nearly half of the allocations generated gains, while the remainder produced a negative result.
On the positive side of the ledger, gold produced the highest monthly return, surging +4.2% as central banks increased their holdings of the precious metal. Managed futures gained +4.0% as equity markets declined, while the Fund’s commodities exposure rallied +3.2%. In addition, credit performed well as leveraged loans produced a +0.6% total return.
Conversely, real estate took the brunt of the damage in April, dropping -4.6%. Infrastructure, also in the real assets bucket, suffered less, dropping by -2.0%. In the hedge fund allocations, risk parity fell -3.7%, long short equity declined -2.5%, and absolute return dropped -1.4%. In addition, the mortgage portfolio had a loss of -1.5% and the arbitrage allocation had a slight negative performance.
ATSX fell -2.5%, compared to the -2.2% decline for its benchmark, the TSX60. Year to date, the Fund is up +4.9% while the benchmark has gained +4.0%.
The performance of Canadian factors was mixed throughout the month. The long-short value, trend, quality, and price momentum portfolios all fell between -0.9% and -3.2%, as the short portfolios outperformed the longs. In contrast, the long-short operating momentum portfolio was the sole factor with positive performance for the month. Nonetheless, the mixed multifactor results led to a slight underperformance compared to the benchmark index.
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Disclaimer: This distribution does not constitute investment, legal or tax advice. Data provided in this distribution should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this distribution is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate Financial Technologies Inc. (“Accelerate”) as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.
