Rethinking private credit for income and defensive portfolios

Private credit has traditionally been classified within the 'alternatives' bucket of a portfolio and grouped with illiquid assets such as private equity, real estate, and infrastructure. For many investors, this category has made up no more than 10–20% of total portfolio allocations.

The rationale was that alternatives offered diversification and the potential for higher returns, but they came with lower liquidity and higher complexity, so were not typically considered core holdings. However, this view is beginning to change.

A key turning point came in 2022, when global fixed income markets posted some of their worst returns in decades. As inflation accelerated, central banks around the world, including the Reserve Bank of Australia, implemented aggressive interest rate increases. Bond yields rose significantly while prices dropped sharply, leading to underperformance in bonds. Many investors, especially those heavily reliant on traditional bonds for downside protection and income, realised that even conventional defensive assets carry some risk.

This has been encouraging some investors to rethink not only the composition of defensive holdings but also the broader role of income assets in portfolio construction.

Moreover, with the hybrid-securities bond market in Australia being gradually phased out by the regulator, income-focused investors are increasingly left seeking alternatives to fill the gap.

Private credit is emerging as one option, offering attractive yields with different risk and liquidity characteristics.

Filling the gap

Against this backdrop, private credit is gaining greater attention as a potential core component of a portfolio’s income and defensive allocation.

While private credit carries risks like any investment and requires careful due diligence, it can offer attributes that align well with the objectives of investors seeking regular income streams and capital stability.

Generally, private credit refers to non-bank lending to borrowers such as small businesses, self-employed individuals, corporate entities, property investors. In return for lending in less liquid, less transparent markets, or potentially to borrowers who sit outside the lending criteria of the larger banks, investors are typically compensated with an illiquidity or risk premium, generating higher yields than they would typically receive from comparable public fixed income instruments.

This premium is a key part of private credit’s appeal, particularly in today’s environment where income is a priority for many. For investors with an income focus, these higher yields can play a valuable role.

The volatility/liquidity trade-off

Another important consideration is volatility. Private credit is generally not priced daily like public bonds and tends to exhibit less day-to-day volatility. While the underlying risks remain, without daily trading, private markets aren’t subject to sentiment-driven volatility seen in listed markets. For investors wanting to reduce exposure to market noise, this can be an attractive feature.

However, the benefits of private credit do not come without trade-offs. Chief among them is liquidity. Private credit investments are typically committed for a set period, depending on the structure of the fund or lending vehicle. As mentioned earlier, this is one reason that there’s often a premium attached to private credit, however it also means investors need to be confident they won’t need to access their funds at short notice. There is also the risk that borrowers may default on their obligations, which could lead to delays in repayment or a loss of part or all of the invested capital. For these reasons, private credit may not suit all investors or portfolio objectives, and position sizing is critical.

It’s also worth noting that there’s lots of variation within private credit as an asset class. Strategies, structures and protections can vary widely, so understanding what is involved and selecting managers carefully is essential.

Ultimately, where private credit fits in a portfolio should be driven by an investor’s individual goals. For those focused on income generation, it can offer attractive yield compared to traditional bonds. For those seeking capital stability with lower volatility, it may serve as a complement to traditional defensives, albeit with less liquidity. And for investors rethinking their fixed income allocations, it offers a way to diversify the balance of return and risk.

As the investment landscape continues to evolve, the rigid compartmentalisation of asset classes may become less useful than a more objective consideration of the role that each asset can play in a broader portfolio. In such a context, private credit warrants a closer look. Not just as an alternative but as a potentially core component of a modern, income-focused or defensive portfolio.

Thinktank’s Income Trust offers sophisticated investors access to a monthly, income-producing asset class, secured against a portfolio of Australian residential and commercial property loans.

Disclaimer: This article is prepared by Lauren Ryan. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.