Blog: Diamonds, Dogs And Central Banks

EXECUTIVE SUMMARY

Diamonds, they say, are a girl’s best friend. For men, it’s a dog. And for private credit fund managers, it’s central banks. Following more than a decade of ultra-accommodative monetary policy, yield-starved investors faced with low/negative interest rates have been forced to accept more risk for less return, driving nominal yields on public credit to historical lows. Private credit, unlike public credit, does not trade and therefore is not directly impacted by monetary policy. This has allowed private credit to largely avoid the negative monetary policy effects seen in public credit, resulting in a significant relative-value divergence between the two. For investors able to hold illiquid assets, we recommend overweighting private credit relative to public credit to increase portfolio returns and decrease risk.

HEROES OR ZEROS?

In 2013, the IMF’s Managing Director referred to central bankers as ‘the heroes of the global financial crisis’. As luck would have it, that person was none other than Christine Lagarde, the current ECB President. In our opinion, Ms. Lagarde’s statement seemed premature (at best) considering the rather sobering statistics¹ related to the current state of the equity market:

• Market cap to GDP ratio at an all-time high (227%); and
• Shiller’s CAPE ratio exceeding pre-Great Depression levels.

Amazingly, these valuations are occurring against a backdrop of post-pandemic uncertainty, rising inflationary fears, a looming stimulus programme withdrawal and record high levels of government debt.

‘HIGH’ YIELD BONDS

Like stocks, credit markets appear overvalued: the ICE BofA high-yield bond index currently yields 2.4%², only half the 10yr average and lower than pre-covid levels.

Bear in mind this figure is non-loss adjusted; with historical high-yield annual default rates averaging around 2%, a nominal yield of 2.4% leaves scant potential for profit. Given this, a rebrand seems in order. Maybe ‘not so high-yield bonds’. Or perhaps, to avoid confusion, we could simply dust off the old sobriquet ‘junk bonds’.STABILITY AT ANY COSTIt is widely accepted that monetary policy enacted post-Lehman has played a major role in the rise of financial asset valuations to their current historically high levels. In the name of financial stability, central banks have aggressively driven down interest rates, expanded their balance sheets via asset purchases, and employed a wide range of unconventional monetary tools to bolster financial asset valuations. With public markets appearing overvalued, the question now is, ‘have central banks gone too far?’ In our opinion, the answer is ‘yes… and likely by a wide margin’.

ACCIDENT WAITING TO HAPPEN

Still not convinced? Then consider the following question: What is the current yield on Italian 5-year government bonds? Before answering, here are a few Italy-related facts to ponder:³

• Italy debt to GDP of 156%
• 1^st place in EU – highest percentage of pensioners
• 2^nd place in EU – lowest level of workforce with a higher education
• Corruption Index ranking – on par with Saudi Arabia and Rwanda

Ready for the answer? Cue drum roll… 0.04%! Without risk of hyperbole, Italian government bonds are an accident waiting to happen. And by comparison, high-yield bonds at historical tights don’t seem so bad after all…

THE ADVANTAGE OF ILLIQUIDITY

With stocks and public credit overvalued, cash at negative yields and certain EU government bonds reminiscent of Argentina’s ill-fated century bonds, where can investors turn? Increasing, they are turning to private credit.

Private credit’s primary advantage may ultimately prove to be its illiquidity

The private credit market has grown fivefold over the past decade⁴ with many of the world’s largest and most sophisticated investors now using alternatives (including private credit) to outperform their peers. A notable example is the Yale Endowment Fund; under the leadership of the late, great David Swensen, the fund’s focus on alternative assets helped it outperform its peer group by a massive 4.3% per annum over the past two decades⁵. Private credit has numerous advantages vs public credit including higher yields, shorter durations, stronger credit protections and non-correlated risk premia. Its primary disadvantage is widely considered to be its lack of liquidity. We disagree. First, given the low yield, low volatility state of today’s market, the opportunity cost associated with illiquidity is minimal. Second, private credit’s illiquidity has shielded it from central banks’ various asset/repurchase programmes, allowing it to largely avoid the negative monetary policy effects seen in public credit. Given this, private credit’s primary advantage may ultimately prove to be its illiquidity.

FINAL THOUGHTS

Monetary policy enacted in the wake of the financial crisis has focused on forcing interest rates lower and financial asset valuations higher, resulting in public credit yields falling to historically low levels. Being only indirectly affected by central bank policy, private credit has escaped much of the yield compression evident in public credit, resulting in private credit now trading cheap vs public credit on a relative-value basis. We recommend investors reduce public credit exposure and increase private credit exposure in order to boost both nominal and risk-adjusted portfolio returns. And whatever you do, steer well clear of Italian government debt! 1 Source: St. Louis Fed, U.S. Bureau of Economic Analysis 2 Source: ICE Data Indices, LLC 3 Sources: Eurostat, Transparency International 4 Source: Preqin 5 Source: YaleNews, Sept 24, 2020