What is diversification?
Diversification is an investment strategy that aims to reduce risk, by spreading funds across a range of asset classes, company sizes and markets. The goal of diversification is to reduce concentration risk in any one investment, and to ensure that if one asset class drops in value, it is compensated for by higher returns in other investments.
Diversification is one investment strategy that has been adopted by several fund managers, including Ray Dalio from Bridgewater associates. However, not all support the strategy, with others preferring to focus on key winners.
How is diversification achieved?
Diversification is achieved by holding investments that have a low correlation with one another. This means that the investments don’t move in the same direction, given economic or market conditions. Ideally, investments would be inversely correlated to one another.
Typically to work out the correlation between investments, investors would use the correlation coefficient. This is a financial calculation to determine the direction of investments with one another. The range is from -1 to +1. Investments that have a low correlation to one another, move closer to -1.
It is important to note, that this is just one way of calculating the correlation between investments.
Ray Dalio is famous for his holy grail strategy, in which he claims that 15 uncorrelated investments can reduce a portfolios risk by up to 80%, without sacrificing returns. Fund managers like Dalio attempt to achieve an attractive level of return over the long term, by effectively spreading their investments across various uncorrelated investments, rather than trying to actively pick “winners and losers”.
The truth is however, that in modern times diversification has become harder than previous decades. This is in part because central banks have now been actively involved indirectly in the movement of markets through money supply increases and emergency interventions. Meaning free market mechanisms aren’t as efficient as they use to be.
How private credit helps to diversify your portfolio?
Private credit is a debt-based asset class that has security for the underlying collateral tied to the loan. It provides investors with ability for legal recourse and is serviced by the borrower’s financial capacity (read more here on what private credit is).
Private credit has been a cornerstone investment of family offices for decades, in particular mortgage-backed private credit. If it’s good enough for the smart money, why not you?
Below we look at some of the correlations private credit has with other investments, to allow you to better determine as to why it should be included in your portfolio.
What is the correlation of private credit with public equities?
One of the unique features of private credit is that it is not publicly traded. This carries two advantages, first it doesn’t carry the same volatility as publicly traded debt or equity. Second, investors can earn an illiquidity premium return.
The disadvantage of the investment is that it is not as liquid as publicly traded debt or equities. Meaning investors may find it harder to sell their investment in a private market and or may have to wait until maturity of the instrument.
Private credit historically has had a low correlation with public equities, as it is not affected by publicly traded market movements. Secondly because it is not publicly traded, the principal value of the instrument usually remains intact, providing the borrower is able to meet repayment obligations and there is adequate security.
Private credit is unique, because if the investment has strong asset backing, in times of borrower distress investors can earn higher returns through penalty interest. Even if the borrower were to completely fail in making repayments, providing there is adequate security, investors can liquidate assets to recoup their principal and penalty interest (plus other legal costs). This is especially the case in mortgage-backed lending.
Furthermore, debt sits higher in the capital structure than equity. This means that in times of financial distress, debtholders have priority over equity holders in any assets being liquidated.
What is the correlation of private credit with publicly traded bonds?
Private credit has a low to medium correlation with corporate and government bonds.
Publicly traded bonds may rise or decrease in price and yields subject to market movements. Private credit doesn’t suffer such volatility as previously mentioned.
Where private credit shares a correlation with government and corporate bonds, is that all three are impacted by the underlying central bank rate.
Typically newly issued corporate bonds and private credit, work at a margin above the risk-free rate.
As the central bank rate moves, so does the returns of newly issued corporate bonds, government bonds and private credit.
Unlike publicly traded government bonds and corporate bonds, whose prices and yields can fluctuate as central bank rates change. Most private credit investments, have a fixed yield, and their principal value usually remains intact until instrument maturity.
What is the correlation of private credit with private equity?
Private equity and private credit are fundamentally two different investment strategies with unrelated outcomes and goals.
Private credit primarily focuses on lending to businesses to produce legally obligated fixed income. While private equity firms take an ownership stake in a business to then add value to it and eventually exit with a higher value.
On paper there is a very low direct correlation between the two asset classes, as one is equity focused and the other is debt focused, which ranks ahead of equity. However, there is a correlation in the fact that if the economic situation of a country were to drastically deteriorate, private business would then be impacted. This would effect their ability to make profits and to service debt, and thus the performance of both assets classes could potentially be impacted.
The advantage of private credit is that even in a worst case scenario, private credit can secure priority over business assets and personal assets of directors if structured correctly. This can include mortgages,caveats and GSAs that would then rank ahead of equity holders and other creditors subject to structuring.
The second advantage of private credit over private equity, is that the business is legally obligated to make interest and debt repayments back to the private credit provider. Whereas dividends of the business are subject to profitability, and management discretion.
Therefore, investors in private equity can effectively diversify their portfolio with exposure to private credit to ensure fixed incomes.
In summary why you should include private credit
Because of the low correlation private credit has with the above asset classes, it makes it a very attractive asset class for family offices to invest in. Family offices will typically use private credit until such time, investments in property development, private equity and venture capital become compelling.
Most of our family office clients, invest in mortgage-backed private credit, that is either first mortgage backed, or second mortgage backed. This is typically referred to as private lending from a the borrower perspective.
Fixed income
Private credit contracts are typically written with interest rates that are at a fixed rate, or in some cases a margin above a floating rate. This provides investors with the security and peace of mind, that they will be provided with a monthly income. Unlike dividends and capital growth, that are subject to market movements, performance and management decisions. Interest repayments are contractually obligated payment that must be paid to the instrument holder.
Security and recourse
Unlike equity investments whether public or private, private credit that is structured properly should offer strong security to instrument holders. This can be a first mortgage, second mortgage, caveat , GSA or PPSR registration against property or other items of value. Security is the core feature of private credit, and investors should ensure that their capital is adequately protected. Private credit also offers legal recourse to enforce the rights of the instrument holder.
To read more about our private credit investments click here.
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