A dynamic allocation approach to private credit

Private credit as an asset class has performed impressively over the past decade, which included a global pandemic and one of the most aggressive tightening cycles on record from the Federal Reserve. In fact, senior direct lending outperformed aggregate bonds by 700 basis points at half the level of volatility since 2012. Current yields for private credit remain impressive with around 200 basis points of additional yield compared to broadly syndicated loans to compensate for illiquidity.

The years after the Global Financial Crisis were characterized by low and steady interest rates, benefiting equities and stable asset allocations. Today, the environment is quite different, with elevated levels of inflation and interest rates and significant volatility in both credit and equity markets. We believe this environment still favors private credit; however, it requires a dynamic approach to the credit cycle that can capitalize on opportunities and dislocations as they materialize.

Private credit is inclusive of direct lending, opportunistic credit, structured credit and broadly syndicated loans (BSLs). We define each in the accompanying appendix of this paper.

Common traits of private credit include high income and total returns due to illiquidity, seniority in the capital structure to recoup value, a secured claim on company assets to support capital preservation, and floating rate coupons with low interest rate sensitivity.

Where these assets differ is their underlying liquidity and risk profiles, resulting in vastly different investor experiences and potential levels of expected returns.

It is difficult to predict the returns of an asset class in any given year. When isolating the annual performance of these credit assets over the business cycle, a few patterns become clear;

1. Full cycle returns of an asset class have been commensurate to the level of risk assumed, with structured credit and opportunistic the top performers.
2. Senior direct lending is a standout without a single negative year and averages high single digit returns with low volatility.
3. Interest rate risk has become a critical issue for long duration fixed income, namely HY; specifically in a world where yields have been low and rising to levels not seen in decades.

Implementing a dynamic credit strategy within private credit is not so simple. There are numerous frictions within opaque and illiquid private markets. It takes time to pick the right manager for an asset allocation and for them to source deals that match their investment strategy. Further, the average maturity of private credit funds is around 5 years. This illiquidity is statistically likely to span multiple phases of the business cycle with limited room to maneuver or exit, regardless of macroeconomic or credit conditions.

A diversified full-cycle approach to private credit may be able to navigate the business cycle in a way that single-strategy allocations cannot. This approach can add to potential total returns by dynamically allocating to opportunistic or structured credit, all the while maintaining a core holding within direct lending. The liquidity component from broadly syndicated loans acts as a lever to deploy capital for positioning and fund shareholder liquidity.