By Dino Zuccollo, head of product development and distribution at Westbrooke Alternative Asset Management
Owing to its ability to generate stable, predictable and comparatively higher yields for investors whilst at the same time improving diversification, reducing overall portfolio correlation and enhancing tax efficiency, private debt investments with experienced managers have increased significantly in popularity in allocations for high-net-worth individuals, wealth managers (and some institutional) portfolios.
But yield enhancement strategies such as private debt weren’t always seen as a genuine means to potentially generate higher returns than those achieved by listed equities, but with significantly lower risk. So how did we get here? We’ll use the UK experience as a case study.
The decade after the Global Financial Crisis was a time of exceptionally low central bank rates, which was music to the ears of equity investors who benefitted from cheap funding available to corporate management teams to drive growth. After cutting rates by 50 basis points in March 2009 to 0.5%, the Bank of England didn’t act again until August 2016 when there was another cut of 25 basis points.
In a market starved of yield, fixed income instruments were seen as a conservative strategy rather than a way to genuinely supplement the returns in a broader portfolio. Just as the cycle started to turn and rates in the UK increased from 0.25% in 2016 to 0.75% in 2018, the pandemic struck in 2020 and rates were slashed to 0.10% in March 2020.
Against a backdrop of practically no yield at all, equities bounced back after the initial shock of lockdowns and value investors nearly burned their textbooks as valuation multiples reached clearly unsustainable levels in the market, thereby defying all logic. Central banks desperately stimulated economies that were full of people staying home, which worked until the spectre of inflation appeared on the horizon.
With global supply chain challenges and a severe demand-supply imbalance as a major catalyst, inflation reached unprecedented levels. Wage inflation has added fuel to the fire, as people in wealthy countries needed to be coaxed back to work with promises of higher wages. Once the flywheel of inflation is spinning, it’s not easy to stop.
The response to inflation from central banks in most countries has been as overwhelming as the rise in inflation itself, with the Bank of England awakening from a decade-long slumber to hike rates twelve times in a row since December 2021. Despite the level of hawkish activity and a base rate of 4.5%, we aren’t even back to the levels seen at the top of the 2000s bull market, which culminated in a rate of 5.75% in July 2007.
In 2007, inflation in the UK was running at between 2% and 3% before the bankers of Wall Street ignited the crisis that marked the end of the cycle. In April 2023, Consumer Price Inflation in the UK printed at 7.8%. It’s not clear that the current hiking cycle is over, which is good news for yield-focused investments and worrying news for equities.
In terms of equities, the FTSE 100 index is flat over both 5 years and 12 months, so the largest and most important companies listed on the UK market are only managing to tread water in terms of shareholder value, with a dividend yield of 3.5% currently quoted on the index.
Smaller listed companies with lesser balance sheets have been struggling, with the FTSE 250 down 10.5% over five years and 9% over the past 12 months, with a currently quoted dividend yield of 3.2%.
The rapid increase in the base rate has had the effect of shifting value from equity investors toward debt investors. With an increased cost of funding and an increasingly difficult operating environment, the debt ducks are quacking the loudest and corporates need to feed them first, with only a handful of crumbs left for equity holders. A base rate of 4.5% that is well ahead of dividend yields on the largest UK indices means that the risk-adjusted return being provided by equity exposure is not appealing in this environment.
Yield is no longer just a conservative ‘stay rich’ strategy designed to avoid major drawdowns in value. Instead, it has become a wealth creation tool again, offering returns that in many cases are better than equity returns even before adjusting for risk.
This begs the question: where can attractive debt returns that offer a reasonable investment time horizon as an alternative to equity exposure be found?
Government bonds can be dangerous for investors, as the value of the bonds is sensitive to changes in interest rates and we find ourselves in a volatile rate environment. Silicon Valley Bank’s failure in the US market was largely due to mark-to-market losses on US Treasuries and forced selling to meet liquidity requirements. Government bonds only offer a so-called ‘risk-free rate’ if held to maturity, a critical point that is missed by many.
Even with the benefit of an inverted UK yield curve that sees six-month yields at just over 5%, this is still a negative real return in the context of current inflation rates. The six-month yield is the best rate currently available on the yield curve, with 10-year yields down at 4.3%. A further issue with bonds is that they don’t tend to be easily available to investors.
In the search for attractive yield with liquidity characteristics that make sense for our investors, Westbrooke Yield Plus invests in predominantly floating-rate private debt transactions mainly in the UK. The floating rate is vital in this environment, as investors benefit from the hiking cycle that doesn’t show any obvious signs of slowing down.
The current yield run-rate is 9% per annum in GBP, which suggests a positive real return in the current inflationary environment. The tax-efficient investment structure adds a further kicker to the yield versus many other sources of yield in the market.
Although a credit risk premium over government bonds is clearly appropriate, the risk-adjusted return is bolstered by Westbrooke’s capital preservation philosophy. Over 90% of the loan exposure enjoys senior-ranking security and 80% of the fund is exposed to real estate or tangible assets.
In this environment, Westbrooke Alternative Asset Management believe that yield is a front-foot strategy that takes advantage of a cycle that is favourable to debt investors at the expense of equity investors.
As the US-based CEO of the world’s largest alternative asset manager, Blackstone, was recently quoted as saying – the current conditions are a “golden moment” for private debt across the globe.