Fixed income, primarily bonds, has usually been a core part of investors’ portfolios. Bonds typically provide steady income, can hold their value or even increase when equity markets decline and generally serve to reduce overall portfolio volatility.
Only, with interest rates as low as they are, bonds have not done any of these things very well lately. The income they provide has shrunk to almost nothing (some bonds even have a negative yield!), their reverse correlation to stock markets has disappeared and 2021 could end up with the worst losses for bond markets in living memory.
And it threatens to get worse. Should the inflation already witnessed in 2021 persist long into 2022, interest rates and yields are likely to rise. That would make the existing low-yielding bonds in your portfolio lose still more value.
“If rates do start to rise, that’s going to be a headwind for liquid credit. Bond valuations will be affected in a negative way,” says Jurgen van Vuuren, Senior Director & Head of Private Debt at Nicola Wealth. That’s why the time may be ripe to consider an allocation to bonds’ lesser-known cousin, private debt. This smaller asset class tends to offer higher yields and lower volatility than bonds, plus a measure of protection against inflation.
“Whereas bonds are easily bought and sold and investors adopt a trading mentality around them, private debt is intended for holding to maturity, requiring a long-term mindset”, van Vuuren says. Bond values go up and down depending on prevailing interest rates; private debt is not nearly so volatile. In return for giving up liquidity, private debtholders are compensated with higher yields: Generally, 5% to 7% for senior secured loans, 10-20% for subordinated loans and more still for distressed debt.
And that’s not the only return on investment. Private lenders typically charge borrowers one-time, up-front loan fees of 1% to 3% as well as penalties for early payment, similar to a mortgage. Some loans come with equity warrants worth a small portion of the company’s equity value that may be sold back to the company for cash.
Further, whereas bond coupons are typically fixed, private loans are mostly on a floating rate. “Loans are priced on LIBOR [an interest-rate benchmark] plus a spread,” van Vuuren says. “When interest rates start going up, your yield on private debt can actually rise.”
Private debt will never be as secure as a government bond, but it’s a possible substitute for at least part of your fixed income allocation at a time when the bond market looks troubled. “We really like the asset class at this time,” van Vuuren says. “It provides strong cash yield in a low-yield environment, downside protection (in that the lender is among the first creditors to be paid should the borrower experience difficulties) and low volatility.”
In the third and final post in this series, we’ll examine the unique way Nicola Wealth makes private debt available to its clients.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. All investments contain risk and may gain or lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities commissions.