Private credit investors look beyond bonds for today’s best yields

While pensions, endowments, and investors of all stripes need income, global market yields remain near record lows as major central banks keep policy rates pegged to zero or below. Fortunately, private credit can offer long-term investors a better-yielding alternative to corporate bonds and broadly syndicated bank loans.

Mainstream markets just don’t yield enough

Roughly a year into the COVID-19 pandemic, the economic outlook remains tepid, and investors have few places to turn for income. In the United States, the 10-year Treasury note yields a nominal 1%, while the 3-month T-bill yields only nine basis points (bps).¹ Negative rates elsewhere, along with tight credit spreads worldwide, have deprived global bond markets of their historical appeal. Meanwhile, low dividend payouts and high earnings multiples have reduced equity return expectations, too.

Negative-yielding debt sets a new world record: US$18 trillion

Negative-yielding debt sets a new world record. Beginning with 2017, this chart shows the growth of negative-yielding debt outstanding, which increased by nearly $6 trillion during 2020 alone, for a total of $18 trillion by the end of the year.

Source: FactSet, December 31, 2020. Figures in U.S. dollars.

When paired with the right partners, though, long-term investors allocating to private credit stand poised to enjoy higher yields, lower price volatility, and broader diversification benefits when compared with those who limit their portfolios to stocks, bonds, and bills. We examine the relative merits of investing in senior credit and junior credit, with an emphasis on direct lending to private equity-backed companies across North America’s middle market.

Private credit offers yield seekers a rare opportunity

While investors holding bonds and broadly syndicated bank loans can always decide to sell their positions in a highly liquid secondary market, direct lenders, or private credit investors, generally enter into long-term relationships with their borrowers. The arrangement affords private credit investors an opportunity to capture an illiquidity premium over yields of comparable quality bonds and bank loans. On September 30, 2020, the current yield differential between high-yield corporate bonds, for example, and private credit stood at roughly 2%. While the illiquidity premium associated with directly originated upper middle market loans has topped 250 basis points in recent years, we believe it resides closer to 150 bps in the current market, in light of today’s low absolute yields and tight credit spreads.² Within the broad category of private credit, two of its subcategories—senior credit and junior credit—offer investors different, complementary attributes.

Private credit’s yield premium provides lenders a comfortable cushion

Current yields, September 30, 2020 (%)
Private credit’s yield premium provides lenders a comfortable cushion. This chart shows current yields as of September 30, 2020; private credit yields roughly 2% more than the next best alternative, U.S. high-yield bonds.

Source: Bank of Canada, Deutsche Bundesbank, Cliffwater, FactSet, Ministry of Finance (Japan), U.S. Treasury, September 30, 2020. See notes below for the list of asset class proxies.⁵

Senior credit for investors seeking capital preservation

Senior credit strategies aim to generate positive real yields by extending secured floating-rate loans directly to middle market companies. Loan financing has shifted from syndicated bank deals toward privately negotiated agreements directly between lenders and borrowers—club execution—representing a less efficient and, by extension, higher-yielding debt market. While the banking industry has been backing away from middle market lending for decades, the trend accelerated following more onerous regulatory capital requirements in the wake of the global financial crisis. For the five years ended in 2000, banks’ share of the loan market stood at 59%, with institutional non-bank investors claiming the residual; for the five years ended in 2019, direct lenders had gained the upper hand, as banks’ share of the loan market had dwindled to only 12%. The bankers’ retreat has created a clear opportunity for non-bank investors able and willing to step in and lend directly to businesses.³

The outlook for senior credit remains favorable. A record $2.5 trillion in private equity dry powder—capital committed but not yet deployed—points to a persistent need for financing to fund leveraged buyouts, add-on acquisitions, and dividend recapitalizations.⁴ With fewer commercial banks making loans to middle market companies, institutional investors with direct lending programs stand to benefit disproportionately. Relative to comparable debt issued by larger companies, middle market senior credit can offer an enviable combination of higher spreads, lower leverage, and stronger covenants—making it a strategy of choice for yield-seeking investors focused on capital preservation.

Junior credit for premium yields, plus upside potential

Sitting below senior credit in a company’s capital structure, junior credit is funded with flexible capital and can include second-lien loans, subordinated debt, and preferred stock with equity-linked upside. Interest can materialize as cash-pay coupons or through pay-in-kind flexibility, depending on the deal structure. Preferred equity with warrants or convertible features and call protection can result in attractive multiples on invested capital. While today’s high valuations plague buyers of most asset classes, large multiples can actually be an advantage to providers of junior credit. Within the middle market, sizable equity cushions below the junior capital tranche provide creditors with extra support, making the debt less susceptible to risk of impairment. Investors in junior credit of leading businesses with strong free cash flow generation, room for operational improvements, and multiple ways to create value can pursue an attractive mix of income and appreciation potential, a pairing difficult to find in today’s market.

Private credit calls for close relationships and specialized expertise

Institutional investors continue to covet private credit, a niche market segment that requires strong industry relationships, especially those with middle market private equity sponsors, many of whom help source private debt financing for their portfolio companies. Additionally, private credit investing demands the ability to properly evaluate complex custom transactions within a relatively compressed window of time. Since opportunities often surface out of a need to deploy debt capital promptly, private credit investors must assess a range of crucial factors fast, such as:

 

Ownership—How capable is the owner of the company in question?

Business—Is the company operating in a growing industry with favorable fundamentals?

Management—Do executive incentives and skills align with the interests of the investors?

Price—Do the valuation, financing, and structure of the transaction represent an appropriate expected risk-adjusted return?

 

Like any skill, distinguishing the most promising deals from those with weaker risk/return profiles requires repetition, and repetition requires access. Tapping into a steady, recurring flow of quality private credit investment opportunities from highly regarded private equity sponsors can be challenging, especially for the uninitiated investor. Many sponsors limit invitations to partners with proven resources that have helped secure prompt and reliable commitments. Now more than ever, direct lenders who have cultivated a strong network of deal-sourcing relationships and developed a discerning eye for asset selection are proving their worth. At a time when investment income has become scarce, long-term investors would be wise to lean into the attractive yields available in private credit.

 

 

 

 

 

 

1 U.S. Treasury, December 31, 2020. 2 Manulife Investment Management, December 31, 2020. 3 S&P, December 31, 2019. 4 Bain & Company, December 31, 2020. Private credit (including junior): Cliffwater Direct Lending Index; private credit (senior only): Cliffwater Direct Lending Index: Senior Only; U.S. high-yield bonds: Bloomberg Barclays U.S. Corporate HY Index; U.S. corporate bonds: Bloomberg Barclays U.S. Corporate IG Index; U.S. core bonds: Bloomberg Barclays U.S. Agg Bond Index; U.S. Treasury notes: 10-year; Canadian government bonds: 10-year; short-term U.S. Treasury bills: Bloomberg Barclays U.S. Short Treasury Index; Japanese government bonds: 10-year; German government bonds: 10-year.

A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other pre-existing political, social and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.


Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.


The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.


This material, intended for the exclusive use by the recipients who are allowed to receive this document under the applicable laws and regulations of the relevant jurisdictions, was produced by, and the opinions expressed are those of, Manulife Investment Management as of the date of this publication, and are subject to change based on market and other conditions. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.


Neither Manulife Investment Management or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained here. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment strategy, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against the risk of loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.


Manulife Investment Management
Manulife Investment Management is the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than a century of financial stewardship to partner with clients across our institutional, retail, and retirement businesses globally. Our specialist approach to money management includes the highly differentiated strategies of our fixed-income, specialized equity, multi-asset solutions, and private markets teams—along with access to specialized, unaffiliated asset managers from around the world through our multimanager model.

This material has not been reviewed by, is not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions. Additional information about Manulife Investment Management may be found at manulifeim.com/institutional.


Australia: Hancock Natural Resource Group Australasia Pty Limited., Manulife Investment Management (Hong Kong) Limited. Brazil: Hancock Asset Management Brasil Ltda. Canada: Manulife Investment Management Limited, Manulife Investment Management Distributors Inc., Manulife Investment Management (North America) Limited, Manulife Investment Management Private Markets (Canada) Corp. China: Manulife Overseas Investment Fund Management (Shanghai) Limited Company. European Economic Area Manulife Investment Management (Ireland) Ltd. which is authorised and regulated by the Central Bank of Ireland Hong Kong: Manulife Investment Management (Hong Kong) Limited. Indonesia: PT Manulife Aset Manajemen Indonesia. Japan: Manulife Investment Management (Japan) Limited. Malaysia: Manulife Investment Management (M) Berhad 200801033087 (834424-U) Philippines: Manulife Asset Management and Trust Corporation. Singapore: Manulife Investment Management (Singapore) Pte. Ltd. (Company Registration No. 200709952G) South Korea: Manulife Investment Management (Hong Kong) Limited. Switzerland: Manulife IM (Switzerland) LLC. Taiwan: Manulife Investment Management (Taiwan) Co. Ltd. United Kingdom: Manulife Investment Management (Europe) Ltd. which is authorised and regulated by the Financial Conduct Authority United States: John Hancock Investment Management LLC, Manulife Investment Management (US) LLC, Manulife Investment Management Private Markets (US) LLC and Hancock Natural Resource Group, Inc. Vietnam: Manulife Investment Fund Management (Vietnam) Company Limited.

Manulife Investment Management, the Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.

531498

Vipon Ghai, CPA, CMA, CFA

Vipon Ghai, CPA, CMA, CFA, 

Global Head of Private Equity and Credit

Manulife Investment Management

Read bio
Joshua A. Liebow, CFA

Joshua A. Liebow, CFA, 

Portfolio Manager, Junior Credit

Manulife Investment Management

Read bio
Matt Szwarc

Matt Szwarc, 

Portfolio Manager, Junior Credit

Manulife Investment Management

Read bio