Investment Outlook 2024: Private Debt and Credit Alternatives
In our Schroders Capital Investment Outlook webinar series, our experts guide you through investing across all asset classes of private markets. Hear our Private Debt and Credit Alternatives experts' insights.
Prominent economic trends such as demographics, decarbonisation and deglobalisation, the “Schroders 3D’s”, are pro-inflationary. The COVID impact on global supply chains has diminished in its effect. Global inflation is moving toward more normal levels. But, the new normal for inflation, owing to the 3D’s, is likely to remain higher.
With the impact of pro-inflationary economic trends, and with normal levels of interest rates remaining higher than what we have witnessed in the post – GFC era. This is not the interest rate environment that investors are accustomed to. As such, navigating this new economic regime requires some adjustments to investment strategy and to asset allocations. Investors can benefit from higher income, insulation from volatility and idiosyncratic risks and build a portfolio more resilient in the face of higher financing costs or later cycle risks.
Step one: Aim for income
This is an income earning environment. With much higher income for both public and private debt, the benefits of an increased allocation to income are clear: greater cash flow, increased security of a higher priority debt payment, and in some cases lower sensitivity to economic outcomes, lower interest rate sensitivity and lower exposure to volatility. Indeed, you can avoid taking risks that you are not well paid to take on.
Step two: Protective income, in secured/collateralised debts
Certain assets increase in price with inflation. A property, such as an apartment, or equipment, may command higher rents (or lease rates) with higher inflation. This increased cash flow can offset this impact of higher debt payments (interest expense) on valuations. A more stable asset value makes for better debt collateral in a rising interest rate environment. As well, where term premiums are low and credit spreads are tight, the highest quality securitised/collateralised debts are among the most attractive income earning assets. Investors do not have to take on material credit risk, or term risk, to achieve higher yields. As well, there is little exposure to idiosyncratic (issuer risk), which is one of the more likely risks we expect to see manifest in 2024.
Step three: Find uncorrelated income
In the insurance-linked securities (ILS) market, because the underlying risk is isolated, a higher interest expense doesn’t increase default risk. Higher interest rates can indeed, even improve the risk / return profile for the ILS asset class in general.
ILS markets are less efficient, currently offering historically attractive returns, owing to supply/demand imbalances in the reinsurance markets. High demand for reinsurance capital is also partially driven by inflation. And this additional need at a time of lower supply has created a favourable set of investment opportunities. Investors can diversify the risks within their portfolio and earn higher income. “More risks, not more risk”, is indeed an attractive strategy today.
Step four: Inefficient opportunities in income
We like the opportunities presented by the wealthier end of the US consumer spectrum. The US consumers that own homes and financial assets, who have a minimal exposure to debt that is not fixed-rate and longer-tenor; they are a key strength of the US economy, which continues to outperform expectations.
Providing financing on a high-priority consumer asset, like a home, is a key opportunity. Critically, with the changes in the Basel regulation for banks in the US, the banks are stepping back from lending. Areas previously dominated by banks are those that will offer very attractive investment returns. Areas such as development financing for residential rea estate (apartments) or leveraged loans that would have previously been made by banks, or even securities that would have been owed on balance sheet by banks are historically attractive. Risk retention partnerships in securitisations, buying pools of loans using the banks as sourcing partners are each attractive ways to access this opportunity. These investments can be public or private and the flexibility to move to provide capital where it is least efficiently moving can be a beneficial way to increase income and reduce risk.
At the end points in cycles, it is important to revisit the relevance of past strategies. Investors should evaluate strategies and investments for their suitability for the new economic conditions, flexibly pivoting to the opportunities the market is affording.
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