Positioning for downturns with Private Debt: The critical role of the attacking defender
The macro investor Diego Parrilla is well known for making the analogy between constructing a successful investment portfolio and building a successful soccer team. It’s possible to extend this analogy to Private Debt, which can provide a winning blend of attack and defence in an investment portfolio. Let’s look at how this analogy works.
In every soccer game, the aim is to score as many goals as possible to win the game. In investing, earning income and generating capital gains are akin to scoring goals. But it’s not enough just to score goals to win the game. The successful soccer team also needs to stop the other side from scoring by defending their position. We can think of this as the portfolio manager’s role of preserving capital and reducing drawdowns.
Let’s put the whole team together. The table shows the role of each asset class in a portfolio corresponding to the role in a soccer team.
As this shows, a successful team in both soccer and investing has a diversity of players or investments – to succeed, each has different strengths, skills, and roles to play. Fielding a team that’s just full of attacking players is like building an investment portfolio with too much equity beta (sharemarket volatility risk) and is only effective in a raging bull market. As it’s skewed too much towards attacking and not focused enough on defending, this unbalanced team or portfolio will get caught offside too often and ultimately concede too many goals or drawdowns in most circumstances.
In a well-balanced portfolio, Private Debt plays the role of the attacking defender or wing back. This is a critical position in every successful investment portfolio and soccer team. Its purpose is to enter the final attacking third and help their team to score, without neglecting the defensive duties at the other end of the field. In the same way, Private Debt provides a regular and stable source of income, akin to the soccer team’s attacking qualities, while maintaining a core focus on capital preservation, which is about defence.
Some of the best attacking defenders of all time include Dani Alves, Cafu, Roberto Carlos, Ashley Cole, Bixente Lizarazu, Phil Neal and Javier Zanetti. While they may not be as well-known as famous strikers and attacking midfielders like Messi, Pele, Ronaldo and Zidane, these wing backs have played crucial roles in some of the most successful international and club teams of all time. In a world of historically low interest rates where income is hard to source, private debt can also provide that winning blend of attack and defence.
Positioning for downturns with Private Debt
Investors turn to defensive alternative allocations to diversify risk and supplement income. In a world of market uncertainty and low interest rates, Private Debt is an increasingly important fixed income option. It can protect capital, provide a reliable income stream and is uncorrelated to traditional bond and equity markets.
As markets work through the impact of the COVID-19 pandemic, accessing stable income is becoming difficult for investors to achieve without climbing too far up the risk curve. Unlike other asset classes, Private Debt can also give investors more certainty they will get their money back, alongside interest or coupon payments. The regular income can either be spent on living expense or used to rebalance the portfolio as opportunities arise.
So, what is Private Debt?
Private Debt or Private Credit involves lending capital as an investment to an entity in exchange for a defined amount of interest and the return of the original capital at a defined point in the future. The investment manager originates and structures the debt via fully disclosed contracts that typically include security over assets and other structural protections.
Like Private Equity, Private Debt involves a private company or entity that needs capital for growth or other business plans. Private Debt is patient capital and the investment managers who work in this area appreciate the benefits of investing in illiquid assets that can provide excess return over the long term.
Negative correlation key to downside protection
As its performance is largely uncorrelated to equities, returns from Private Debt help dampen listed market drawdowns in times of market stress.
To illustrate this, we provide a study using the last 20 years of data combining a Private Debt benchmark based on BBSW plus a gross credit spread of 450 basis points less 50 basis points of modelled credit losses, which is consistent with big four bank loan books, and using the actual net returns from our core Private Debt strategy for the most recent two years.
Let’s compare the correlations, compound returns and volatility outcomes for a range of portfolio constructions shown below:
- 100 per cent exposure to Australian Equities based on the ASX 200 Accumulation Index.
- 60 per cent exposure to Australian Equities and 40 per cent exposure to traditional Fixed Income with the Bloomberg AusBond Composite 0+ Yr Index.
- 60 per cent exposure to Australian Equities, 20 per cent exposure to fixed income and 20 per cent exposure to Private Debt.
- 60 per cent exposure to Australian Equities and 40 per cent exposure to Private Debt.
How it fits – portfolio inclusion of Australian and New Zealand Private Debt
Compound returns and volatilities over a 20-year period (2001 to 2020)
Australian Private Debt is negatively correlated with the ASX 200 Index (-8%).
Let’s examine the potential growth of an initial A$10,000 investment over this 20-year period. This analysis demonstrates how an allocation to private debt can help to achieve better return outcomes and smooth out returns in a balanced portfolio.
Portfolio Composition Analysis – growth of A$10,000 over a 20-year time horizon
As this analysis demonstrates, a balanced portfolio delivers superior returns and lower volatility or capital stability when an exposure to Australian and New Zealand Private Debt is included in the portfolio, which translates to a higher portfolio Sharpe ratio. This ratio helps investors understand an investment’s return versus its risk.
These results are impressive given 20 years ago the ten-year government bond yield and the RBA cash rate were both above five per cent. These starting points are far more favourable to traditional Fixed Income versus the current ten-year government bond yield of 1.1 per cent and RBA cash rate of just 0.10 per cent.
Much like Private Equity is considered to be a core allocation alongside listed Equity, Private Debt is an increasingly popular allocation to complement existing traditional fixed income allocations.
The illiquidity premium is one of private debt’s key attributes. Private Debt, just like Private Equity, doesn’t have a liquid secondary market. So, the illiquidity premium may compensate investors for locking up their money for a period. Liquidity risk, however, needs to be carefully and individually assessed by each investor. Investors suited to this type of investment tend to have a long-term investment horizon and a buy and hold approach to this part of their portfolio.
One criticism of this the study may be the modelled level of losses is too low. The manager’s ability to add alpha is critical, assuming the big four banks’ loan books are a proxy for the market beta for private debt. Top tier Private Debt managers have consistently delivered returns above this range over this time period for large, sophisticated institutional clients.
As a soccer team prepares for an unfamiliar opposition each week, it makes sense to include an attacking defender in the line-up. Whilst scoring goals is the main objective of the game, ensuring that the opposition does not score more goals than your team is equally important. As markets evolve, investors will continue to seek returns that provide genuine diversification in their portfolios.
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Simon is responsible for portfolio selection and management and a co-founder of Revolution. Simon is an experienced private debt portfolio manager specialising in asset backed securities such as RMBS, CLOs, Consumer and Equipment ABS.