Private Credit Investing in Rising Rate Environments
Why could rising rates be on the way?
Improving pandemic conditions, private sector liquidity, pent-up consumer demand, and fiscal stimulus have combined to drive prices and rates higher. Investors are facing clear signs of near-term inflation and the potential for rising rates off exceptionally low levels. Given this backdrop, and the near record high duration of aggregate bonds, many investors may find themselves overweight long-duration fixed income.
Figure 1: Historical Yield of a 10-Year Treasury Note (1953-2021)
Source: Federal Reserve, as of 3/31/21. This time period was selected because Blackstone believes it captures long-term trends in interest rates and the unusual nature of low current yields on Treasuries. The information herein is provided for educational purposes only and should not be construed as financial or investment advice, nor should any information in this document be relied on when making an investment decision. Opinions expressed reflect the current opinions of Blackstone as of the date hereof and are based on Blackstone’s opinions of the current market environment, which is subject to change. Past events and trends do not imply, predict or guarantee, and are not necessarily indicative of, future events or results.
Figure 2: Cumulative Mutual Fund & ETF Flows (1/1/2020-Present)
Source: Investment Company Institute data from Bloomberg, as of 5/19/2021.
What has made private credit more resilient in rising rate environments and therefore, we believe, an attractive consideration for investors today?
Floating Rate Loans. With rising rates expected in the next cycle, long duration investors may struggle to earn the same returns as they did in the last cycle. Private credit tends to be floating rate, which may limit the rate risk that is inherent in traditional fixed income today.
Privately Negotiated Deals. With private credit, investors can access a wide funnel of deals, and the manager aims to select only the best ones. Private credit managers generally aim to negotiate better structures, including senior secured and with covenants which make them more defensive strategies. Private credit transactions are bilateral by nature and are negotiated directly with the issuer, which is often the private equity sponsor.
Less Volatility. Less volatility is expected in the asset’s valuations because private loans are not traded. Managers generally aren’t forced to mark to market during periods of economic dislocation. Private loans have offered relatively low historical volatility, while still maintaining attractive returns, when compared with the public markets.1
Credit quality improves with the economic recovery. The credit quality of issuers generally improves with economic recoveries, something which reduced the recent credit risk concerns that peaked in April 2020.2 Rising rates are an outcome of a highly synchronized economic recovery and could become a force to reckon with.
Fixed Income Duration
- Long duration makes fixed income assets more sensitive to changes in interest rates
- Higher Treasury yields are expected to result in larger drawdowns for traditional fixed income returns
Figure 3A: Impact of Rising Treasury Yields on Traditional Fixed Income (Based on Bond Prices and Treasury Yields as of 6/11/2021)
- We used market duration and the 10-year Treasury yield to model the total return of the Bloomberg Barclays US Aggregate Bond Index
- The model aims to show how much of the bond index’s total return is due to its average duration and the 10-year Treasury yield
Figure 3B: Projected Total Return Loss to Traditional Fixed Income (Based on bond prices and Treasury yields as of 6/11/2021)
Source: Bloomberg and Blackstone Investment Strategy, as of 6/11/2021. Projections based on a linear model that decomposes the price of the Bloomberg Barclays US Aggregate Bond Index on the index’s average duration of underlying securities and on the 10-year Treasury yield’s level and 30-day percentage change, based on daily data from 1/3/89 to 3/25/21.
Access Private Credit Investing in Rising Rate Environments
1. Morningstar, over a 15-year period ending December 31, 2020. Volatility is measured using standard deviation. Morningstar computes standard deviation using the trailing quarterly total returns for the appropriate time period
2. Blackstone Credit as of December 31, 2020; JPM Default Monitor, April 1, 2021
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