Special Report: How Private Credit, Subject of Scary Forecasts, Came Out a Winner

Forsaken by major commercial banks after the 2008-09 financial crisis, small businesses turned to private lenders for financing. Qualms were rife that this non-bank lending, which unlike traditional bankers enjoys no federal backstop, would founder in the next downturn.

That didn’t happen to the asset class. And plenty of institutional investors that have since added private debt to their portfolios are reaping the rewards. Not blowout, Tesla-style gains, certainly, but solid, mid-single digits in a low-interest time, with some hitting the low teens.

Private debt funds tend to pay 2 percentage points or so more than investment grade corporate bonds yield. Small wonder that investors, vexed by low-lying fixed income yields, have piled into the space.

One very pleased investor, for instance, is the $42 billion Arizona State Retirement System, which as of last year had 15% of its portfolio dedicated to private debt. The results have been pretty decent, with a 4% gain over one year—that’s compared to minus 6.9% for its benchmark, the S&P LSTA/Leveraged Loan Index—and 9.3% annually over five years, versus 3.4% for the bogey.

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And in October, the California State Teachers’ Retirement System (CalSTRS) announced a $1 billion investment in direct lending outfit Owl Rock Capital.

Private credit “is well diversified across sectors, geography, and strategy, with loans experiencing low credit loss,” noted Al Alaimo, the Arizona program’s senior portfolio manager of fixed income, in a statement.

The concept has been around since the 1950s, and it accelerated leading up to the financial crisis, when it got squashed along with everything else. With the banks’ retreat, though, private debt has recaptured its mojo, and then some.

Assets under management at private debt funds have rocketed to $850 billion globally last year from less than $200 billion in 2007, per stats from research firm Preqin. Fundraising dipped last year, but the funds still have almost $300 billion of uninvested capital.

To be sure, some private credit-supported companies have failed. Like British department store chain Debenhams, founded in 1778. The company’s private lenders ended up owning it last April. The retailer eventually said it was going into liquidation.

As last year’s economic storm clouds gathered, forecasts were dire for private debt. During the pandemic’s initial wave in May, ratings agency Moody’s Investors Service projected private loan default rates would be between 11% and 21% in 2020.

What actually happened was much less drastic. The default rate for private credit popped up to 8.1% in 2020’s virus-spooked second quarter, an increase of 2 percentage points from the first period, according to an index run by law firm Proskauer Rose. By the third quarter, the rate had fallen back to just 4.2%.

Numbers on how private debt investments have fared overall are thus far hard to get. Like private equity (PE) funds, they make investments whose outcomes may not be known for many years. “Private debt is not visible or trackable,” said Jason Brady, CEO of Thornburg Investment Management.

Many funds need not adjust the valuation of their holdings, provided that borrowers keep paying interest. That’s different from banks, which must recalibrate their loan books’ value in light of the changing economic situation and their take on borrowers’ ability to repay loans.

Private credit benefits from the number of deep-pocketed players who have entered the field, including Wall Street investment banks and PE firms. Prominent are such heavyweight as Ares, Apollo, Bain, Blackstone, KKR, and Goldman Sachs.

Taking a look at large scale investments, last fall, Blackstone closed the largest real estate debt fund in history ($8 billion), with a chunk of it reserved for private transactions. On the smaller side, various family offices have lent money to Pizza Hut franchises.

With an investment this tasty, in a time of low interest rates, the appeal is obvious.

Special Report: Why Pennsylvania SERS is Moving Toward a Liability-Driven Benchmark

Promise of Private Debt Burns Bright—With a Big If

CalSTRS Allocates $1 Billion to Direct Lending Firm Owl Rock Capital

Canada’s Public Sector Pension Manager Adds New Private Debt Chief

Tags: Arizona State Retirement System, Banks, Blackstone, CalSTRS, KKR, Preqin, Private Credit, Private Debt, Special Report Fixed Income 2021, Thornburg Investment Management

Recently, we reported that BlackRock expects inflation to move up. So the nation’s largest asset manager advocated buying Treasury inflation-protected securities (TIPS) as a remedy.

One easy way to invest in these is via the largest exchange-traded fund (ETF) that tracks inflation, the iShares TIPS Bond ETF. Since our story, this has risen 0.75%. Equally as important is the so-called breakeven rate, which shows what bond traders are projecting for inflation up ahead. (The rate is the difference between Treasury bonds and TIPS.) Namely, it foresees a 2.1% annual inflation rise for the next decade.

Considering that the latest increase in the Consumer Price Index (CPI), year-over year for December, was 1.4%, that 2.1% call is a pretty decent indication of how inflation expectations are heading. Now, the Federal Reserve is targeting 2% as the ideal level for inflation, and even will let it run above that point for a while without clamping on the monetary brakes, for fear of kneecapping the economy.

Yes, there’s no guarantee that inflation actually will oblige by moving higher. The Financial Forecast Center thinks the CPI will break 2% annually by March, and stay around 3% through the summer. But Goldman Sachs believes that the Federal Reserve’s preferred inflation gauge, the personal consumption expenditures, will top 2% sometime this spring, as the pandemic weakens and economic prospects brighten, then fall back.

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Peter Boockvar, CIO of Bleakley Advisory Group, pointed out that, while prices for goods are flat or dropping, service costs are on the way up. Hospital services, for instance, increased 3% over the previous 12 months. That should feed into higher inflation down the line, he predicted.

After the Fed’s most recent meeting, Chairman Jerome Powell indicated that the economy could see some price pressures, in particular from rising energy costs. Indeed, oil prices have ascended to $53 most recently, after slumping to less than zero last spring. (The most recent top, at the end of 2019, was $63.) Climbing oil prices, he said, could “send a shock through the economy.”

Certainly, additional federal spending would test the proposition, which up to now has proven valid, that government stimulus doesn’t move the inflation needle. President Joe Biden has proposed a third aid package, to the tune of $1.9 trillion. Whether he gets that or not—and GOP lawmakers are balking at the price tag—Washington oddsmakers expect he will manage to push some kind of stimulus through, given the severity of the pandemic’s winter surge.