As I mentioned in my article last summer, there are many types of alternative investments. Within this discussion, we created two categories, alternative asset classes and alternative strategies. A subset of alternative strategies is alternative (‘alt’) credit. From where we sit, there are great opportunities presently in the alt credit area. In this piece, I’ll discuss why we like this area of the capital markets.

Background on Investing in Traditional Bonds

When building a portfolio of bonds, investors often seek securities where interest payments are fixed, like a traditional bond, and when there is a specific date that the bond matures. A bond makes the same payment every six months, with the principal being paid at maturity. Investors often take comfort with the defined nature of bonds and especially like them when the credit quality is from an institution like the US federal government or large credit-worthy corporations.

From a return perspective, typically the longer the maturity of the bond, the higher the expected return, or yield to maturity. This higher return justifies the longer period before the principal is returned to the investor. The yield to maturity usually has some relationship to expected inflation rates. Investors should want a return above the inflation rate to tie up their money. This is called the “real return.”

Since the Great Financial Crisis of 2008-2009, there has been very little difference between the inflation rate and the rate on traditional bonds. In essence, the real return has been close to zero.

Moreover, the absolute rate on bonds had been low as the Federal Reserve Bank (‘Fed’) kept interest rates low to stimulate the economy. That was until 2022. Over the past 15 months, the Fed has raised interest rates from near 0% to 5.25%, one of the fastest rate increases ever. The result was the worst year of bond performance in over two generations, with the total return on the bond market index in 2022 being a loss of approximately 13%^[1].

At Strategic Wealth Partners, we have been troubled with the low absolute level of interest rates and the low after-inflation rate on bonds for years. This led us to seek out ways to help clients achieve a safe low volatility return that also provided a differentiated return stream to the stock market. This is important, as a key attraction to bonds is their ability to diversify a portfolio that includes stocks by reducing the overall risk of the portfolio.

Introduction to Alternative Credit

Enter “Alternative Credit.” This is really a catch-all sub-category for strategies that are different than traditional investment-grade bond strategies. Our objective was to find credit investments where we believed we could achieve lower volatility and higher total returns than traditional bond market investments.

One area of alternative credit that we look at is private credit. With these securities, a corporation will privately negotiate terms like the interest rate, maturity of the security, and size of the issue with a large institutional investor, such as an insurance company, a mutual fund or limited partnership.

The investor will typically hold onto this debt instrument until it matures, which in-turn creates limited liquidity for the investment. Because of the limited size of the issue, and the anticipated limited liquidity, these types of investments often offer higher returns than publicly traded bonds. Also, because the securities do not trade frequently, if at all, pricing can be determined more formulaically, which can reduce the volatility of the investment.

More on Private Credit

A key component of private credit securities is whether investments are offered with a fixed coupon or with floating rate interest payments. The floating rate structure is extremely beneficial to investors during periods of rising interest rates, as we have experienced these past 15 months. Often private investments are not rated by the major rating agencies. This requires investors in a mutual fund or limited partnership to rely on the credit experience of the manager of the fund or LP.

The difference in yield on private credit investments relative to traditional bonds can be quite significant, often reaching 4% to 6% higher than US Treasury securities with similar maturities. If an investor is confident with the credit quality of the private credit investment, this yield differential is very attractive. Given the interest rate increases of the past 15 months, current yields on private credit investments can exceed 10%. At the present return levels, investors can often reach their investment objectives with less expected volatility than traditional portfolio mixes. This is where there is a large opportunity for investors.

Also, many of these private credit investments are currently selling at discounts to their maturity value. This means there can be an opportunity to generate an additional positive price return as the private credit investment moves closer to maturity, which naturally moves the value of the investment to its par value. Again, if one believes in the underlying investments, it is possible to achieve total returns (price change plus current yield) in excess of 10% over the next several years.

Importantly, should the economy fall into a recession, the high current cash yield can buffer the total return if markets question the value of the underlying investment. The result can still leave the investor with a reasonable total return. This situation is fairly common in today’s environment, offering investors a safe-guarded investment.

Despite a large increase in interest rates in the past year, some publicly traded traditional fixed-income securities are still offering a yield that is just barely higher than inflation, and for many maturities, yields are actually lower than inflation.

In our minds, private credit, both floating rate and fixed rate, can offer rare opportunities to generate attractive returns to portfolios consistent with a desire to beat inflation and reduce the volatility of the return stream.

If you have questions about alternative credit and whether it fits into your portfolio, please contact us for a review. We are always happy to help.

^[1]iShares Core US Aggregate Bond ETF (Link)

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