DC pension schemes could expect to see an additional 2 to 5 per cent return a year by investing in private credit strategies, according to a new paper from a US-based research body.
This white paper is published by The Defined Contribution Alternatives Association (DCALTA), which publishes information on alternative investment strategies relevant to the DC market.
Its latest publication looks at the growing private credit market and its increasing inclusion in DC strategies in the US.
The report says that this premium is available from private credit markets when compared to the investment returns on publicly-listed corporate and high-yield bonds.
The report also details the growth of private markets and private credit strategies. It says that private markets now comprise 13 per cent of institutional portfolios on average, with 86 per cent of global investors allocating to this asset class. Within this, it says private credit is “quite common” in institutional portfolios, with commercial real estate, direct lending and residential real estate being the most prevalent types of private credit investment.
Outlining the expected return premium, the report said direct lending can deliver a 2 per cent or more premium, while specialty finance can deliver a premium upwards of 3 per cent. It added that investment-grade private credit is expected to deliver a premium of just 0.3 to 1.5 per cent.
However the report adde that the premium on real estate or infrastructure credit would depend on the capital structure and rating of the investment.
As well as potentially higher returns, the report says there are also other benefits in allocating to private markets. It says that thanks to its reliance on income to generate returns, as well as the typical senior position of direct lending in the capital stack, direct lending has been able to provide stable returns with relatively low drawdowns.
In addition, most private credit assets are based on a floating interest rate, which protects the investment from interest rate risk in a rising rate environment.
The report adds: “During the most recent period of inflation-induced rate-rising cycles, the interest rate on private credit loans increased. This contrasts with the fixed-rate high-yield and investment-grade market, where bond prices moved down significantly due to increasing interest rates.” It adds that within wider DC schemes, managers can combine floating and fixed-rate instruments to optimise interest rate flexibility.
The report also says private credit is increasingly being utilised in multi-asset strategies like Target Date Funds, which are a core part of US DC schemes, as they are in theUK. The report says: “[TDFs] are long-term focused. They have the liquidity profile to benefit from allocating to private credit relative to the swing of the position within the entire portfolio or across a grouping of TDF vintages.”
The report takes an in-depth look at the primary considerations needed to implement private credit within a DC framework. It says key considerations for managers are valuation frequency, liquidity management and performance measurement.
It also explores reasons behind the growth in private credit over the past 15 years. It says private credit has historically had a higher cost of capital than the traditional public credit market, and so conventional wisdom would suggest that below-investment-grade, middle-market businesses utilise private credit. However, given the growth of these markets, there are now a number of reasons why high-quality businesses consider private credit. The report authors say: “We believe its ability to command a higher cost of capital has been due to its ability to provide greater sophistication, flexibility, customisation, speed and certainty of execution, and also the ability to evaluate complexity that may impede more traditional lenders.”
The report concludes: “Private credit presents a compelling opportunity to enhance retirement outcomes in DC plans by offering higher yields, diversification benefits and lower correlation to public markets compared to traditional fixed-income investments.
“Key benefits include a yield premium of 2 to 5 per cent over public bonds, floating-rate structures that mitigate interest rate risk and stable cash flows from senior secured loans. However, challenges such as illiquidity, quarterly valuation frequencies and higher costs of capital require careful implementation.”
The report adds that strategies like integrating private credit into professionally managed multi-asset portfolios, and utilising collective approaches while also deploying robust benchmarked metrics, can help address these hurdles.
