This article was written in collaboration with Maxence Louvrier.
Relative to fixed income.
At the start of 2021, robust support from monetary and fiscal policy buoyed asset prices across markets. In the US, fading monetary support and high valuations are holding back assets for the coming year. According to analysts, the European and Japanese markets are more welcoming to private investors as central bankers are perceived to be more patient and inflationary pressure lower.
In 2021, most investment grade bonds did not exceed the 3% returns level. For investors willing to bear more risks, high yield bonds averaged at 6%. We can observe that the former did not even compensate for the inflation observed in 2021, especially in Q3. Even when mixing bonds with equities, to create a traditional 60:40 portfolio, subsequent returns may strongly differ from the last decade. Indeed, it has been expected that such an investment strategy will yield only around 3.5% a year for the next decade. Thus, many investors are now turning to alternative investments to compensate for the lack of returns from fixed income.
Private debt, also known as private credit, has proven to be the best alternative to fixed income, sharing the same investment characteristics with recurring income but generating much higher returns than the former. Private debt investment is the allocation of capital in private structures’ debt with the expectations of generating a positive return. Private credit in the last 12 months has yielded to investors an annualized return of 8.0%. As stated before, the risk level of private debt is comparable to the likes of bonds. One of the main reasons is because there are areas within private debt, such as senior-secured direct lending, where loans can be protected by strong collaterals that, in case of failure to reimburse from the borrower, can be seized in a relatively fast manner.
The second reason why institutional and private investors allocate capital in private credit for 2022 is the returns. To achieve the before-mentioned yields, private debt funds have several specific strategies. By definition, companies contracting debt from a non-banking institution need a fast stream of cash, thus accepting higher interest rates. Only a small percentage of these rates illustrates the riskiness of the loans. Most of it reflects the extra work, due diligence, and capital readiness that private debt funds need to arrange for the loans to be supplied, usually in the matter of a couple of days. Then, by issuing loans with a maturity ranging from a few days to a few months to many companies, the fund will assure both a required level of diversification and a high liquidity.
2022 will generally be a good year for private investors, with global real GDP figures expected to average at 4.5%. This is thanks to many factors, including but not limited to an improved health situation, easing of restrictions and aggressive policy support. Thanks to all these efforts, the global economy has grown by about 6.1% this year, in what is now the strongest post-recession recovery in more than 80 years.
As we approach 2022 and central banks appear to be ready to decrease policy support, some worry that default rates will increase thus scratching returns. However, when analyzing such an effect on companies, the effect of supportive macroeconomic framework must not be undermined. As stated before, most economist and analysts agree that 2022 will continue to be a desirable year for public and even more for private credit markets. Furthermore, central bankers are unlikely going to unwind the interest rate hiking cycle fast by fear of undermining economic recovery. These factors thus create a fertile soil for private debt to give institutional and private investors better returns in 2022.