Industry view – Nest Craig Mitchell is an economist at Nest


NEW LANDSCAPE, NEW CHALLENGES


If 2022 taught us anything, it’s that “safe” assets may not be quite as safe as we thought. For many investors, bonds have been the common tool to balance risk in portfolios. And yet, one of the most widely watched bond indices, the Bloomberg Global Aggregate Bond Index, was down 16% by the end of the year.


A negative 16% return in an asset class commonly used to balance portfolios is a tricky position for long-term investors. While we don’t think investors should throw out portfolio construction princi- ples, it poses serious questions for those relying on the typically negative correla- tion between debt and equities. Inflation has remained persistently high around the world, and central banks have responded by increasing interest rates at a rapid pace and undertaking quantitative tightening.


The impact of higher interest rates and slowing economic growth are giving investors pause for thought. The era of easily available credit, with ultra-low interest rates, appears to be over for now. Defaults should be the big concern for


credit investors. Warren Buffett famously once said: “When the tide goes out you get to see who was swimming naked.” Due diligence is key, and investors will find out in the coming year whether they have been thorough. Suppressed yields on sovereign and highly rated bonds have encouraged investors to explore riskier and higher yielding asset classes to boost returns and try to meet investment targets. These have been enticing options, more so because average default rates have been low by historical standards. For example, high-yield default rates are around 1% versus a long-term average more like 3.5%. It’s a straightforward con- clusion to expect default rates will increase given the economic backdrop. In 2022, companies warned about reve- nues, saying high inflation will eat into households’ budgets and lower sales. There are ways to mitigate risks in the credit space. For a start, lending through private credit can offer greater reassur- ance than their public counterparts and historically, has generated excess returns compared with public debt instruments. Default rates have traditionally been lower in private markets and recovery rates on defaulted debt are typically higher¹. Cur- rently we are not seeing a significant rise in defaults but that could change. Lenders in the private space may feel more reassured given the potential for negotiating protections into terms, and the ability to directly interact with compa- nies that may be struggling. Private lend- ers can also be compensated for taking on illiquidity risk. The illiquidity premium does not always exist though, as public


bond spreads react faster to changing conditions. Investors need to be mindful of pricing and whether they are being adequately compensated for the risk. With borrowing becoming more expen- sive, liquidity concerns should only push up the premium investors can access. As the yields on government bonds have risen, investors will require a higher interest rate on corporate debt and a suffi- cient illiquidity premium on top for pri- vate corporate debt. At Nest, some of our members will be investing for 40-plus years. That gives us something we can leverage in helping boost their returns. What’s more, the use of floating rate instruments in direct private credit means investors can receive higher absolute returns as interest rates rise. This is an opportunity to protect the lender when inflation is high. Existing public bonds with fixed rates will be hurt by falling prices as yields rise.


Whilst floating rate notes means that cor- porates will face these higher costs imme- diately, if chosen carefully, direct lending offers a lucrative opportunity as compa- nies struggle to find credit elsewhere. It’s one of the reasons why private credit, or alternative lending, has expanded so much in the past two decades. While I’ve focused on direct lending, investors can also benefit from putting money into other private assets, such as infrastructure and real estate debt. Portfo- lio diversification is about more than listed equities and bonds.


1) Public versus private debt – what’s the difference? www.abrdn.com/en-us/institutional/insights-thinking-aloud/ article-page/public-versus-private-debt-whats-the-difference


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a.holt@portfolio-institutional.co.uk 10 | portfolio institutional | March 2023 | Issue 121


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