Imagine a world where individuals don’t have credit cards, can’t get personal loans or mortgages, where governments can’t borrow money to finance deficits or where corporates can’t fund merger and acquisition (M&A) transactions, research and development (R&D) or dividends.
The size of global public equity markets is estimated to be worth $120trn, considerably larger than equity markets. But when most people think of investing in credit, they think of the global financial crisis (GFC) of 2008 and the world’s economy flatlining due to banks investing in risky loans.
Credit markets have changed a lot since then. The disintermediation of banks in credit markets started in the 1970s and accelerated after the global financial crisis. Credit products used to sit on banks’ balance sheets, funded by overnight liabilities. This means there was a big mismatch between long-term assets and short-term liabilities on banks’ balance sheets, which could lead to bank runs as we saw in the GFC.
How corporate credit investing works
Investing in corporate loans primarily involves money being loaned to privately owned companies and then interest is collected on these loans, which is mandatory and typically paid quarterly, meaning there is strong visibility on cashflows coming into a fund – returns can then be paid to investors.
When those loans are extended to large, multinational, market-leading companies, the chances of credit losses are lower than (for example) loans to small and medium-sized enterprises (SMEs) in emerging markets.
Moody’s estimates that corporate default rates will decline to 3.6% by the end of 2024, from a peak of 5% in January. What is equally – if not more – important than default rates, is recovery rates, or how much a lender recovers if there is an event of default.
Credit as a risk diversifier
A well-diversified portfolio should have at least some credit exposure. It is an effective way of balancing risk and can act as the defensive play in portfolios – the more stable ying against equities more volatile yang – a good way of providing some protection for portfolios against market volatility.
With a large number of equity indices at or near all-time highs, and income on credit products still elevated due to higher base rates, there is a strong argument to be made to increase one’s allocation to credit products.
Is investing in credit available to retail investors?
In today’s world, the largest investors in credit products are insurance companies, pension funds and sovereign wealth funds, which tend to be financed with long-term liabilities. This makes credit markets – and the global financial system – more stable and resilient.
But asset managers are increasingly making these credit products available to retail and private wealth channels as well.
So what makes investing in corporate loans appealing?
Investing in loans is boring
Unlike a lot of things in life, when it comes to investing in credit, boring is good. Boring signifies safe, predictable returns, not the high stakes of the riskier spectrum of equity markets.
Of course, it’s down to the portfolio companies – lending to high-growth, cash-burning companies is riskier than lending to stable, global businesses with predictable cash flows. This helps reduce portfolio volatility and gives access to regular income, which makes forecasting returns more predictable.
Loans are different than bonds
One of the main advantages of loans is that they rank senior secured in the capital structure. This effectively means that this group of lenders are first in line to be paid out if there were to be an event of default, while lenders also have security over most of the assets of a company.
If a company defaults on a loan, the asset manager is then effectively in a position to take control of the company and sell the business – as a whole or in pieces – to minimise credit losses. This is very similar to a bank repossessing a house if someone defaults on their mortgage.
Defaults are bad for equity investors in a business as they typically lose all their money, while senior secured lenders may be able to recover all or part of their initial investment.
The balance to volatile equities
Corporate loans have a low correlation to equity markets, which means when shares are selling off, loan prices are steadier. Credit investments are considered to have a lower risk profile than equities because they aren’t subject to this volatility. Because of the high recovery rates discussed earlier, loans tend to be resilient during periods of macro volatility.
Central bank interest rate protection
Loans often carry floating rates – this means they are not fixed and they change or ‘float’ in line with changes in interest rate policy – so there is always a spread above central bank rates. This means investors are afforded some protection from central banks’ interest rate decisions and it shields them to an extent from rising or falling interest rates.
Typically, in periods of high inflation, central banks will increase base rates and income on the fund will go up, while in periods of low inflation, central banks will lower base rates and income on the fund will go down. This means floating rate instruments – in a way – provide investors with a natural hedge against inflation.
Inflation has been incredibly volatile in the past few years and is likely to remain volatile, driven by geopolitical tensions, low growth, the transition to greener energy sources and an ageing population. This means that investors who have credit exposure in their portfolios should consider at least part of that to be floating in nature.
Why credit investing is good if you’re retired
Investors can choose to take income from their credit investments or are given the option to reinvest those funds. This makes credit investing an interesting option for people who are looking to generate income streams if they are in retirement.
The diversification point, and credit’s relationship to equities, are also advantages for retirees, as is the inflation-protection nature of credit investing.
Private markets are large and offer diversification
According to the US Census Bureau, there are 32 million privately owned businesses in the US, while there are only 6,000 publicly traded companies. Within these privately owned companies, there are some very large and very small companies.
The largest privately owned business in the US generated $165bn in turnover and employs 155,000 people globally. To put this in context, this is roughly equivalent to Meta or Johnson & Johnson’s annual revenues. Private markets are huge and can offer diversification in portfolios that are typically heavily skewed to publicly listed companies.
Conclusion
Credit investing is not the shady, menacing market that a lot of the headlines from the GFC era would have you believe. Within credit markets, investors can take all sorts of risks and as with any investment, looking under the bonnet is good practice.
All-in yields on loans are very attractive in today’s world while the underlying instruments provide downside protection in case the global economy hits a few speed bumps. As we said, corporate credit investing is boring. And boring is good.
Pieter Staelens is managing director and portfolio manager of CVC Income & Growth. The views expressed above should not be taken as investment advice.