From Paul Chin, Director – Head of Investment Strategy, Jamieson Coote Bonds
Chasing those enticing yields? High yield credit funds can seem like a golden ticket. They promise strong returns compared to other asset classes, which might make them look like the smarter choice. But before diving in, it’s crucial to understand that not all fixed income assets are created equal. High returns come with their own set of risks, and knowing what those are can help investors make more informed investment decisions.
The emergence of private credit funds
As banks reduce corporate lending, private credit funds are gaining popularity, increasing competition and financing options. These funds use various strategies to generate returns, so careful consideration is needed. Key factors to assess include sector focus (e.g., property construction vs. stable industries), business stage, capital structure (e.g., loan repayment priority), and loan term.
Credit funds, including those focused on more speculative private credit and property construction loans, often attract investors with the promise of higher returns. They offer elevated interest rates because they invest in debt issued by companies with lower credit ratings. While the potential for greater income is appealing, it’s essential to understand that these higher yields come with substantial risks.
Private credit funds often face liquidity issues due to long lock-up periods, extended redemption times, and infrequent trading. These funds involve direct lending, so loans are not traded on exchanges, making it hard to recall or trade capital.
Credit funds are primarily at risk from defaults, where issuers may fail to make interest payments or repay principal, especially during economic downturns. Investment values can fluctuate due to market sentiment, company performance, or economic conditions. High yield bonds, for instance, may lose value if a company faces financial troubles.
Also read: US Fed To Cut Rates: It’s Not The End Of The World As We Know It
Valuation in private credit is critical, impacting returns and risk. Periodic valuations may not reflect current conditions, and inflated valuations can reduce liquidity. This trend is increasingly problematic in the private credit industry.
Property construction loans, a subset of private credit funds, come with their own set of risks that can amplify the overall risk profile of high yield credit funds. These loans are typically provided to developers for building residential or commercial properties and are often characterised by high interest rates due to the inherent risks involved. Construction projects can face many challenges in tighter times, such as delays, cost overruns, and regulatory hurdles. If a project encounters significant problems or fails to complete on time, the borrower may struggle to repay the loan, increasing the risk of default. The financial health and track record of the developer is critical in assessing the risk of default.
Balancing Risks and Rewards
Credit investments can offer attractive income opportunities, but they come with the potential for significant volatility and default risk. To navigate these risks, a diversified investment approach can help. Balancing high yield credit funds with more stable investments, such as government bonds or investment grade securities, can provide a buffer against the risk of high yield investments.
Ultimately, the quality of private credit depends on the investment managers behind it. Their expertise in assessing and monitoring loans, managing risk, and protecting capital is key. Additionally, their experience, industry relationships and track record across various market cycles are essential factors.
Government Bonds: A safe haven in a volatile environment
Government bonds typically perform well during economic uncertainty and downturns. With sustained inflation and higher interest rates, the real return on existing bonds can become less attractive compared to new issues, which might offer higher yields. However, government bonds retain their appeal due to their stability and lower risk profile. And, within a government bond fund, portfolios are diversified with individual bonds maturing being steadily replaced by newer issues, which helps these funds keep pace with return needs.
When interest rates start to decline, the value of existing government bonds with higher coupon rates is likely to rise. Lower rates mean that newly issued bonds will offer lower yields, making existing bonds with higher rates more valuable.
Which investment takes gold?
So, where does that leave investors? High yield credit funds and government bonds each play distinct roles in an investment portfolio, much like different events on the track. High yield funds are akin to the high-risk, high-reward sports, where taking on greater risk can lead to the potential for impressive returns, much like a daring pole vault or a thrilling sprint. These funds might suit investors prepared to handle the volatility and aim for those high yield medals.
On the other hand, government bonds are like the marathon—steadily paced and reliable. For investors seeking stability and a steady income, government bonds are your marathon runners, providing a dependable performance over time. They are well-suited for investors who value consistency and want to avoid the unpredictability of higher risk investments.
Ultimately, the choice should align with an investor’s financial goals, risk tolerance, and how they view the economic landscape unfolding.
