Financial advisors pipe up on private credit allocations

With bonds generating low returns over the past 10 years and negative total returns in 2021 and 2022, Joseph Spada, private wealth advisor at Summit Financial, says his clients have been seeking higher returns for a sleeve of their fixed income portfolio. To meet this need, he turned to private credit because the asset class has generally generated higher fixed income returns and, since they are floating rate, made money in 2021 and 2022 as interest rates rose.

“They are an excellent diversifier to public bonds that lose principal when rates increase like they did in 2021 and 2022,” said Spada. “The floating rate feature provides a hedge against inflation and rising interest rates.”

To mitigate the risk of private credit, Spada says he uses funds that loan money to companies that are financially backed by private equity because they can step in if the company is having financial difficulties. He also prefers loan-to-values averaging around 40 percent, to provide a cushion against the collateral dropping in value.

“Almost all the loans are senior-secured so they get paid back first if there are defaults or bankruptcies,” said Spada. “We always diversify our personal credit allocation between loans collateralized by the balance sheet of private companies and real estate.” 

He sees private credit as a diversifier to - not a replacement for - public bonds. For most of his clients he will allocate around 30 percent of their fixed income allocation to private credit, primarily split between loans collateralized by private companies and real estate.

Meanwhile, Stephen Tuckwood, director of investments at Modern Wealth Management, remains favorable on private credit despite worries about Federal Reserve rate cuts lowering yields, specifically direct lending given the focus on first-lien senior-secured loans.

“With direct lending yields being based on a floating base rate, the asset class also fits our view that interest rates will be higher for longer,” said Tuckwood. He adds that his preferred vehicle to access direct lending managers is via perpetual non-traded BDCs given the added transparency and semi-liquidity versus private funds.

When it comes to asset allocation, his view is that a private credit allocation would be funded from a high yield corporate bond portion of a diversified portfolio. 

“Given the tight spreads in the high yield corporate bond market right now we also view direct lending as relatively more attractive, but only for those with the ability and willingness to forgo liquidity,” said Tuckwood.

Speaking of liquidity, Ryan Quinty, vice president financial planning at Cyndeo Wealth Partners, says private credit is a great way to add to diversification to a client portfolio, despite it being an asset class that often lacks liquidity.

“There is an additional premium of income and return that is attractive,” said Quinty. “And furthermore, we hedge liquidity and credit risk by limiting our exposure to the asset class.”

In Quinty’s view, having a 2 percent to 7 percent allocation exposure to private credit allows the client to “appropriately enjoy the additional premium on return while still managing risk.”

Meanwhile, Christopher Davis, partner at Hudson Value Partners, places private credit within the “absolute return" category of alternatives. For parts of an investor's allocation where liquidity and taxability are less of a concern, he believes private credit can be a good fit. He also says he prefers diversified direct lending strategies more focused on the traditional middle market.

“If considered as part of a fixed income allocation, we still think liquid credit should be the majority of the holdings. If thought of within an alternatives allocation, we would typically target one third or less in private credit,” said Davis.

On the other hand, Brian Glenn, CIO at Premier Path Wealth Partners, says he is not using private credit in any client portfolios at this time, despite the attractive yields due to worries over principal risk.

“Nobody borrows at 12 percent or 13 percent because they want to, they borrow at that rate because they have to,” said Glenn.

Glenn views the Russell 2000 Index as a proxy for private credit where he sees the average return on assets in the 6 percent neighborhood, excluding those with negative earnings.

“If a company’s assets only generate 6% returns, how can they fund double digit debt interest rates on their debts? There are large amounts of investor capital entering the private credit space, partly because traditional banks are deemphasizing,” said Glenn. “History is littered with credit cycles peaking when large amounts of money and lenders entered while rates increased.”