Alternative credit investments refer to debt investments in assets outside of traditional fixed income securities such as government bonds and investment-grade corporate bonds. They provide investors exposure to unique credit opportunities not available in public markets. With the tightening of bank regulations after the 2008 financial crisis, alternative credit has seen significant growth as an asset class over the past decade. This article will provide an overview of the major types of alternative credit investments, their risk and return characteristics, and the benefits they can provide for investment portfolios.
Private debt funds provide financing to companies not served by banks
Private debt funds provide loans and financing to small and medium-sized companies that cannot readily access credit from banks. This is a massive market, with an estimated $4 trillion funding gap for small business loans in the US alone. Private debt funds help fill this void. They can tailor loan terms and covenants providing flexible solutions not offered by banks. Private debt funds provide an illiquidity premium for investors, targeting returns in the 10-15% range.
Collateralized loan obligations provide exposure to leveraged loans
Collateralized loan obligations (CLOs) pool together leveraged loans to provide diversified exposure for investors. Leveraged loans are made to companies that already have considerable debt burdens, often used to finance acquisitions, buyouts, or recapitalizations. CLOs tranche the credit risk of the leveraged loans into rated securities. Equity tranches offer higher potential returns for investors willing to bear default risk. CLOs offer exposure to the growing leveraged loan market and chance to earn high single-digit to low double-digit returns.
Distressed debt funds invest in the bonds and loans of troubled companies
Distressed debt funds specialize in investing in the bonds and loans of companies that are in financial distress or bankruptcy. The fund managers use their expertise to identify securities trading at discounts to potential recovery values. They may take an active role negotiating with creditors and restructuring the companies. Distressed debt investing requires specialized skills but offers the potential for equity-like returns from the rebound of troubled companies. Median returns historically have been in the mid-teens.
Alternative credit provides portfolio diversification and stable income
A portfolio allocation to alternative credit can provide diversification from mainstream assets like stocks and investment-grade bonds. Alternative credit has a low correlation, providing good balancing properties in a portfolio. The steady cash flows generated can be used for income, liability matching, or funding commitments. endowments, pensions, family offices and other institutional investors have been increasing allocations to alternative credit.
Alternative credit encompasses a range of private debt investments that provide financing outside of traditional markets. They provide access to unique lending opportunities not served by banks and the liquid bond market. The illiquidity premium offered can generate high single-digit to mid-teen returns from specialized credit strategies. A modest allocation to alternative credit can enhance portfolio diversification and income.