What investors need to know about the booming private debt world

You may have noticed you’re hearing more about private debt (also known as private credit) as an asset class these days. You’re not imagining it. Private debt is booming as an asset class. Preqin estimates the sector’s assets under management will grow from US$1.5 trillion in 2022 to US$2.8 trillion by 2028, reflecting growing awareness of the sector’s solid income generation credentials.

Volatility, or lack thereof, is also a key selling point for private debt after last year when the supposedly defensive income-generating bond sector fell off a cliff. Investors reacted by shifting funds from bonds to private debt, and this trend shows no signs of abating.

Before you join the crowd in making the shift into private debt, it’s worth digging deeper into the attractions and risks of this increasingly popular asset class…

What is private debt?

Private debt funds lend money to companies in a similar way to the banking sector. Their financial return is generated from floating rate interest payments paid by the companies they lend to. The interest rate paid by each corporate borrower is generally priced at the RBA’s cash rate plus an appropriate risk premium.

So private debt fund managers invest their fund’s capital across a portfolio of corporate loans which results in regular interest being received and paid out to investors.

At the end of each corporate loan, private debt funds either receive the principal back or agree to refinance. High quality private debt funds are adept at ensuring their downside risks are protected on each of their loans before and during this process.

Private debt funds have a range of corporate loan types to choose from. Lower risk funds tend to focus on senior secured and investment grade debt, which are particularly attractive during rate rising cycles when fixed rate bonds are underperforming. Higher risk funds often focus on sub-investment grade debt, mezzanine debt and subordinated debt where returns are higher reflecting the heightened risk profile.

The private debt sector’s income-focused returns are generally attractive. For example, typical Australian private debt returns were in the 9-11% range during 2023, and benefitted from the RBA’s rate raising cycle.

The nature of private funds means they aren’t listed on the stock market. Hence, volatility isn’t a significant risk with most of these funds. This is a major attraction for investors who are aiming to invest in defensive assets which they expect will maintain their value during periods of market weakness.

The outlook for private debt

If the RBA maintains the cash rate at roughly current levels throughout 2024, the private debt sector is on track to deliver similar returns this year as in 2023 (9-11%).

Having said that, the outlook for private debt will be affected if there are any more cash rates changes by the RBA. But let’s be honest about the accuracy of interest rate predictions. Not many economists (read none) correctly predicted the number of rate increases during the RBA’s recent rate raising cycle.

For what it’s worth, there’s a growing chorus of economists who are expecting the RBA to start cutting rates from September. For example, Commonwealth Bank are forecasting three 25 basis point rate cuts by the end of 2024, bringing the cash rate down from 4.35% to 3.6%. All other things being equal, that would translate into slightly lower returns for the private debt sector in the year ahead.

A key difference versus bonds

It’s also worth noting that private debt is very different from publicly listed bonds because there’s a low risk of capital loss. In general, the value of each private loan’s principal remains stable throughout the loan period, whereas publicly traded bond values tend to decrease when interest rates increase.

However, that also swings the other direction for private debt. When rates are falling, private debt is unlikely to benefit from capital gains as the publicly listed bond sector tends to.

This difference is particularly relevant for investors to understand at this juncture. It means if the RBA is approaching a rate cutting cycle, then private debt faces a relatively less attractive outlook versus bonds. And of course, vice versa.

Higher interest rates have created a noteworthy risk

There’s also an important risk that investors should be aware of before they invest in private debt.

Whilst rising interest rates have been positive for private debt returns of late, it raises the risk that companies paying a 500+ basis point premium above the RBA’s cash rate on their debt may be starting to struggle to service their loans.

This stress is likely to have hit some companies hard and fast because the recent rate raising cycle was unusually speedy, while the floating rate nature of private debt means each RBA rate rise has been affecting companies in real time.

But it’s not a code red situation

Given the private nature of the private debt asset class, it’s challenging for investors to gauge how much loan servicing stress there is across a portfolio of corporate debts.

At this juncture, it’s probably a safe assumption that a small portion of the corporates lent funds by the fast growing private debt world are to some extent suffering debt servicing stress.

However, with official interest rates starting the year 1.25% higher than a year ago it seems likely it’s only causing a minor impact at this stage.

Data from Metrics confirms this. It shows the corporate banking sector’s maximum write-off was only 0.67% of their credit books back in March 2010, while recent write-offs are a small fraction of that amount. This provides a degree of comfort for private debt investors that this risk is minor at present.

It’s also worth bearing in mind that high quality private debt funds aim to mitigate against the risk of debt write-offs by diversifying their funds across a portfolio of relatively short duration loans with a regular churn of repayments to ensure a healthy liquidity profile.

Private debt stands out as a defensive asset class

After last year when private debt proved its defensive and income-generating attributes, it stands out as one of the more defensive of the mainstream income-generating asset classes. Hence, the outlook for private debt assets under management remains bullish in the coming years.

However, investors should remain cognisant of the risk of growing debt servicing stress across private debt portfolios, as well as the possibility that private debt underperforms the bond sector in the event of a rate cutting cycle eventuating.

As with most asset classes, investors are advised to invest with specialist private debt managers with long-term track records of outperformance.

Disclaimer: This article is prepared by Simon Turner. 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.