Private markets continue to be a destination of choice for institutional investors to achieve greater yield and potentially higher returns. With an array of alternative exposures, investors are considering high yield, public real assets and bank loan ETFs to provide flexibility and efficient access to liquidity to complement private market allocations.
Performance and risk metrics will tell any investor that most private credit opportunities should be considered as part of a platform. While private credit capitalizes on a relative lack of liquidity to achieve price stability and impressive income/returns outcomes, there are logistical challenges with investing in such an illiquid and gate-checked asset class — like other alternatives. The first is meeting liquidity needs, and the second issue is, after the decision to allocate to private credit is made, “OK…now what?”
A major challenge and unknown for allocators is forecasting when committed capital will be called and how to optimize that planned investment in the meantime. Depending on any combination of the type of private investment, manager preference, and the opportunity set of that market, the time from committing an investment to it being called can take as long as 2+ years. The draw down pathway will vary as well — likely somewhat chunky as the manager identifies opportunities. One solution to keeping committed capital invested, is to use indexed high yield as a “bullpen” for when capital is called.
From a comparative standpoint — when considering options for your asset allocation, high yield poses as the most attractive asset class to serve as the liquidity bullpen, with higher correlation to private credit (direct lending) returns than other asset classes and yields closer to those of broad private credit. Think of it as private credit-lite (and liquid). This makes sense as, at a fundamental level, high yield and private debt represent a leverage component of a company’s balance sheet.
|Mark-to-Market/Liquidity||Correlation with U.S. Private Credit* (qtrly ret.)||Expected Yield**|
|U.S. Private Credit*||Periodic||8-12%|
|U.S. High Yield Index||Daily||0.82||5-9%|
|U.S. Aggregate Bond Index||Daily||-0.15||2.5-5%|
|S&P 500 Index||Daily||0.66||1-3%|
*Private Credit is represented by the Cliffwater Direct Lending Index (CDLI)
**Expected Yield represents a historical range representative of the trailing 10-year period.
Source: Cliffwater Direct Lending LLC and Bloomberg as of March 31, 2022 based on quarterly returns going back to April 2012. The above targets are estimates based on certain assumptions and analysis made by Cliffwater Direct Lending LLC and Bloomberg. There is no guarantee that the estimates will be achieved. All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment.
Additionally, by using the liquidity and volatility of high yield, investors can take advantage of widening spreads during market dislocations. Because of the lack of volatility/dislocation and timing issues with unpredictable capital calls, this is not possible with private credit alone. In meeting capital calls, investors may be selling high yield into strength, enjoying gains otherwise missed.
Here we have identified 5 instances where high yield spreads approached or exceeded 6%, representing points in time when adding to the liquidity bullpen as a proxy for putting private credit capital to work would yield enhanced returns.
High Yield Spreads vs. Rolling Annual Income of Private Credit
This data is based on current market observations as of the dates noted and should be used for illustrative purposes only. Several factors could result in substantially different terms, including, but not limited to, the seniority of the loan and risk profile of the borrower.
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