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[Editor’s Note: Do not read the following article as a recommendation to invest in private debt. Like all investments, private debt has risks. Private debt can have less transparency and liquidity compared to listed securities on exchanges. As for any lender, the main risk is debts not being repaid in an economic downturn. Do further research of your own or talk to a licensed financial adviser before acting on themes in this article].

In Metrics’ view, private debt is becoming a mainstream investment option in Australia. Private debt marries the needs of local businesses for new sources of financing with increasing investor demand for income at a time of low interest rates. 

With inflationary pressures increasing and likely to trigger increases in official interest rates as soon as the first half of 2022, the characteristics of private debt are a consideration for income investors. 
 

Portfolio diversity

When interest rates plunged to record lows in recent years, investors had limited options to generate yield and secure income from the financial markets. At the start of the pandemic, even some stocks paying high dividends were subject to those dividends being deferred, cancelled or reduced. 

Popular income alternatives, such as listed hybrid securities issued by the banks, come with the risk that they will be converted to shares if the issuer strikes trouble, increasing the investor’s exposure to equity at the worst possible time.

By contrast, private debt can potentially meet investor demands for income without the volatility of financial markets and the equity risks attached to shares or hybrids, in Metrics’ view. 

By participating in a diversified pool of loans to large companies across a wide range of industries, investors can use private-debt exposure to potentially aid portfolio diversification and generate income, in Metrics’ view.
 

From alternative to mainstream

The global financial crisis (GFC) sparked the growth of private debt - in two ways. First, banks were forced to become more conservative in their lending and to hold increased capital against certain types of loan assets. This restricted the availability of business credit and forced a search for alternatives. 

Secondly, by slashing rates to near zero in a bid to stimulate economic growth, central banks forced investors to look beyond traditional investments such as bonds or term deposits to generate income.

Private debt filled these needs and is now estimated to be a US$1 trillion-plus market globally, double what it was in 2015 [1]. In Australia private debt is estimated to be 10% of the corporate loan market, but heading towards the 40-50% share of non-bank lending now seen in Europe [2]. In the US, the banks’ share of lending to small and medium business has shrunk from 30% in 2010 to 20% while in US commercial real estate, private debt is estimated to account for 60% of the market [3]. 
 

Established form of finance

Private debt is one of the oldest forms of finance, but without the layers of cost and regulation attached to the banks, which are the dominant providers of business finance. 

Firms like Metrics Credit Partners assess loan applications using the same criteria as the banks, with the aim of providing investors an attractive risk-adjusted return. Loan terms, security, and covenants are negotiated to provide finance at a fair price and then monitored through regular contact with the borrower. 

This is designed to provide an extra degree of investor protection and sets private debt apart from alternatives such as corporate bonds, where debt exposures are bought and sold on a screen and there is little or no relationship between the investor and the borrower. 

Private-debt processes also allow for rapid adjustments as circumstances change and can also help with the adoption and monitoring of environmental, social and governance factors increasingly sought by investors. In effect, you are earning income just as banks do.
 

Risks

The main risk of private debt is credit risk or the deterioration of the financial performance of a borrower resulting in the non-payment of principal, which can result in capital loss. 

However, the processes in approving and managing the loan are designed to protect against the likelihood of loss. Loans are typically secured against the real or “hard” assets of the borrower, sit at the top of the capital structure and are given priority over equity and other unsecured creditors under Australian Corporate Insolvency Law. Equity holders take the first loss and the lender has the ability to recover the cost of dealing with a default from the borrower.
 

Rising rates drive increased interest

One feature of private debt that has attracted more investors is the way it performs relative to other fixed income investments at a time when interest rates look set to rise. Because private debt is typically issued with a floating interest rate that includes a margin over the benchmark, there is an increase in income from rising interest rates that helps protect capital. 

Typical fixed-rate investments do not offer this feature and investors who hold them in a superannuation fund would face a capital loss as rates rise. Applying the inverse relationship between bond prices and bond yields – prices fall as yields rise and vice versa – a fund would be required to “mark to market” the value of the bond.

[1] Moodys Investor Services, reported in The Economist, 23/2/202.2 https://www.economist.com/special-report/2022/02/23/more-borrowers-turn-to-private-markets-for-credit

[2] Ibid

[3] ibid

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The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate (“ASX”). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice.  Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.