The rising appeal of floating rate private debt in portfolio diversification

This article was produced in partnership with Trez Capital.

Elevated interest rates compelled the banking sector to scale back their lending activities. This development is intensifying a trend that has been evolving for over a decade. Since the Global Financial Crisis and several regulatory reforms, hedge funds, private-equity funds and other alternative investment firms have been gradually diverting resources away from banks. Currently, expectations are that the private debt sector will soon outgrow the traditional syndicated debt market previously led by traditional lenders.

Sandra Ferenz, Managing Director, Portfolio Manager and Product Strategy at Trez Capital, has identified a notable shift in sentiment towards alternative investments since 2022. Ferenz attributes this change is largely due to the resilience demonstrated by real estate and other alternatives, particularly in a challenging inflation and interest rate market environment.

Ferenz explains, “For investors focused on saving for retirement, private assets and alternatives offer an attractive option due to their potential for higher returns, often attributed to the illiquidity premium associated with these investments. This makes them a beneficial addition to a retirement portfolio.”

“Reflecting on 2022, it was a year where both stock and bond performances were negative, challenging the efficacy of the traditional 60/40 portfolio model that many investors have relied on for a long time,” notes Ferenz. “This underperformance has prompted investors and portfolio managers to reconsider their allocation strategies and explore the benefits of diversifying or increasing allocations to alternative investments.”

This latest development is an intensifying trend that has evolved for over a decade, culminating in what many have dubbed “The Golden Age” of the private debt sector as it steps in to bridge the gap.

The hedge against inflation

“With private debt, you're typically priced at floating rates, therefore you have a credit spread over an index benchmark, like the Wall Street Journal Prime (WSJP) or the Secured Overnight Financing Rate (SOFR),” Ferenz explains. “This structure means that as interest rates rise, so does the yield on investments. You’re capturing those rising rates in times of inflation but limiting downside risk since you're also putting in floor rates within private loans,” she adds.

Ferenz highlights the contrast between floating rate debt and traditional fixed income in terms of response to inflation. “If you compare floating rate debt to more traditional fixed income, bonds are being devalued when inflation and interest rates are rising. Floating rate debt, on the other hand, has a mitigating hedge impact in the portfolio. This aspect is crucial for investors looking to maintain portfolio value during economic fluctuations.”

Higher yield and lower duration

On private debt Ferenz elaborates, “Because it is privately negotiated, you can command higher rates. There is that illiquidity premium, as it is not tradable on a day-to-day basis like a public market asset.” Furthermore, the shorter-term nature of these loans allows for flexibility and adjustment to market conditions. “You're not only benefiting from the index rates rising, but also from resetting credit spreads, which can be advantageous in a rising rate environment,” Ferenz adds.

The security offered by floating rate private debt is another key benefit. Ferenz notes the importance of physical security, such as real estate, and strong collateral.

“You're often in a senior position, so in the event of default, you can step in, take over, workout the asset, which ultimately leads to higher rates of recovery,” she states.

This factor becomes particularly critical in times of uncertainty, providing a solid safety net for investments.

Navigating real estate investment amid sensational headlines

While discussing the resilience and recovery potential of investments secured by physical assets like real estate, Ferenz highlights the need for informed decision-making in this sector. She also points out the importance of understanding different asset classes within real estate and the long-term trends driving the market.

Ferenz advises investors to consult experts and look beyond sensational headlines, especially in real estate, where local dynamics and nuances play a significant role.

She recalls a pivotal moment in 2021 for Trez Capital’s investment approach.

“Historically, for the equity side of the business, we were focused on short-term funds, primarily dealing with opportunistic builds like multi-family apartments across the U.S. Sun Belt,” Ferenz explains. However, recognizing the potential in their high-quality assets, Trez Capital pivoted to a more long-term strategy. “We saw the opportunity in holding these assets for the long term, creating a unique product structure that transitioned from opportunistic to long-term hold funds,” she adds.

This strategic shift involved building assets from the ground up and not only allowed Trez Capital to participate in the development profit, but also enabled investors to hold onto quality assets for long-term income generation.

“It became a really unique offering in the marketplace, giving our investors the chance to capture upside on the development profit side, while also holding quality assets for long-term income,” says Ferenz.

With interest rate cuts on the menu, some worry private debt could slow down. However, the key principle in the private debt sector is discipline. This approach, focusing on thorough and prudent underwriting, is viewed as the most effective strategy to avoid areas of tension that are emerging in the credit markets.

“The key factor that becomes crucial in this context is evaluating both the sponsor and the asset. Particularly in times of uncertainty, the credibility and strength of the sponsorship hold paramount importance,” Ferenz says.