As high volatility persists in the capital markets, investors continue to struggle with the impact of higher inflation and rising interest rates. More investors are seeking for alternative ways to add diversity to traditional strategies as a means to preserve capital and earn strong risk-adjusted returns.
Let’s see how investing in short-term private debt can address aggravated challenges in the current market environment:
Concern #1: Volatility - Public vs Private Debt Strategies
As private loans are not publicly traded, yields on these instruments can be insulated from some of the volatility swings in public markets. This can be perceived as a negative as information on what’s really happening in the underlying portfolio inter-period may not show up as quickly. The risk attached to this lack of transparency is mitigated with income-producing assets, especially those that turn over frequently such as trade finance and revolving loans – with each turn, as income is realized risk on maturing assets is removed and the portfolio is rolled and current. Private debt allocations can help lower overall portfolio volatility over time.
Concern #2: Inflation – Strong Returns as an Offset
In July 2022, the annual rate of inflation as measured by the consumer price index (CPI), reached 7.6% (Statistics Canada) – increases in consumer prices in the last 3 months have been the largest since the first quarter of 1983. With such high inflation, investors are actively seeking assets that can effectively act as an inflation hedge. Inflation hedging refers to investing in assets that target above average risk adjusted returns as an offset to the decreasing purchasing power of money.
Private debt, historically, has been an attractive investment opportunity generating higher yields in comparison to public fixed income alternatives. The stronger performance in these investments can be attributed to higher coupon payments and origination fees while providing principal protection through collateral support.
Concern #3: Rising Interest Rates – Fixed vs Floating Rates
With the Bank of Canada attempting to slowdown the overheated economy through aggressive monetary policy/rate hikes, more Canadian investors are looking for alternative ways to earn consistent returns and diversification for traditional fixed income strategies that can be negatively impacted by rising interest rates. Interest Rate Sensitivity measures how much the value of a fixed income asset will fluctuate because of the changes in interest rates.
When negotiating a deal, direct lenders can structure interest payments in either fixed or floating form. It is common for private loans to set these payments at a fixed spread over a floating short-term reference rate, such as bank prime rates. Historically, bank prime rates tend to rise simultaneously with changes in overnight rates, providing positive interest rate sensitivity to investors investing in floating rate private loans.
To summarize, allocations to short-term private debt can be a good tactical addition to your portfolio, particularly in market environments characterized by above average volatility, high inflation, and rising interest rates. Speak to your Investment Advisor about the benefits of private debt investing or reach out to Cortland Investors team to learn more about short-term private debt investing.
*This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. All investments contain risk and may gain or lose value.
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