Assessing Private Credit Risk & Return in a Falling Rate Environment

With a rate cutting cycle underway, it can be tempting to search for higher yielding investments. However, it’s important to also consider risk in a volatile and uncertain environment.

We’re well and truly into an interest rate cutting cycle in Australia.

For the many Australians who rely on their investment portfolio for income, this means the income generated from floating rate investments has likely decreased accordingly. For investors who target a fixed amount of income for retirement and living expenses, this shift can feel unsettling.

It’s easy to see the appeal of floating rate debt in a rising rate environment, because the income adjusts upwards with the cash rate. The counter to this is when rates come down, so too does the yield.

In this situation, investors may start looking at investments which offer a higher yield or are less impacted by the official interest rate reduction.

However, it is important investors understand the benefit of floating rate investments; they are compensated for a corresponding level of credit risk. Reallocating to assets that produce higher income often means taking on a greater level of risk, whether that’s reduced liquidity, default risk, or asset risk.

A mindset shift

Some investors approach income investing from the top-down. They start with the figure they want to draw, say $100k a year, and find investments that target that amount of income. This is opposed to looking at the level of income and capital volatility their portfolio can reliably sustain based on the risk they’re comfortable to take.

The risk is, if an investor has, say a $1 million portfolio, generating that kind of income, year in, year out, might mean investing into riskier assets when interest rates are declining, which could jeopardise both capital and yield. It’s understandable to be frustrated when income yields decline when investing in floating-rate investments, but it is pertinent for investor to ask themselves how much risk they are prepared to take for the yield and overall return they’re chasing. Especially when defensive, less volatile assets offer valuable diversification within a broader portfolio.

The temptation to move up the yield curve is understandable when returns are falling, but there’s enduring value in lower-risk, income-producing assets as part of a diversified portfolio. These might not be headline-grabbers, but they can offer a reliable income stream and help reduce volatility.

A portfolio with an allocation to debt markets offers investors exposure to a less volatile asset class where prices don’t represent consumer or market sentiment shifts exhibited by public markets such as listed shares.

Exploring the catalysts for rate cuts

While it may be un-nerving for investors when their yield and income declines due to cuts in the RBA cash rate, it is important to explore the catalysts for rate cuts and the relative health of the broader domestic economy.

The RBA cut rates in response to elements of softness in the economy. Slower growth, subdued inflation, and geopolitical uncertainty are all drivers, among others. RBA Governor Michele Bullock described it in her speech following the May monetary policy decision as “a complete rollercoaster”.

That’s not a green light to go up the risk curve for the sake of income but a cue to check downside protection and make sure an investment portfolio can weather economic weakness or market shocks.

An additional factor to consider and one of the uncomfortable side effects of a weaker economy is a rise in arrears and defaults, particularly among lower-rated borrowers or sectors under pressure. If margins are thin and demand is falling, business borrowers may start to struggle with debt repayments, while we know many personal borrowers have been struggling with the rising cost of living for some time.

That’s why it’s not just about income but also capital preservation. Investors might be chasing a higher income return, but if there's an elevated real risk that the borrower can’t make their payments, it’s a fragile trade-off at the margins and some investors may not be appropriately compensated for the risk they are taking. Particularly since achieving higher yields tends to mean moving further up the risk curve.

Track record and consistency of returns

There are a considerable range of factors that investors should contemplate when selecting an investment – particularly one that is focused on income. Track record and longevity of the manager through multiple economic and credit cycles as well as consistency of returns are some of the reference points that may underpin investors with confidence in the investment.

By way of example, Thinktank has a 19-year track record and has never missed a single scheduled interest or principal payment to our investors. As with any investment, risks apply. Investors should refer to the relevant Information Memorandum or Product Disclosure Statement for a full outline of the risks associated with Thinktank’s investment products.

As interest rates continue to adjust, potentially reducing the income return, investors might reasonably begin to consider chasing higher yielding products. Before taking this step, they should think about whether they will be appropriately compensated for any additional risk. It might also be worth considering the value of factoring in a balance of defensive assets in their portfolio.

Disclaimer: This article is for general information only and does not constitute financial advice. It has been prepared without taking into account your objectives, financial situation or needs. Past performance is not a reliable indicator of future performance. Thinktank’s investment products are available to wholesale investors only (as defined under the Corporations Act 2001 (Cth)).