Private credit enters your 401(k)? What investors need to know

Retirement investors seeking diversification traditionally turned to bonds to balance out stock market movements. But in recent years, bonds have developed a positive correlation with stocks, prompting retirement investors to seek alternatives to fill the gap.

Enter private credit, an alternative investment that involves providing loans to businesses outside traditional channels. Although private credit is not new to the investment world, several factors currently in play are making it more attractive to retirement investors.

Using private credit to address problems in the bond market

A shift in the bond market is one of the main reasons private credit is now on the radar of retirement investors. Whereas bonds traditionally had a negative correlation to stocks - moving up when stocks moved down and vice versa - factors including the recent surge in inflation have resulted in a positive correlation. Consequently, investors looking for diversification need an option other than bonds.

The performance of private credit investments is generally dependent on the health of the borrowing company, rather than stock market sentiment. Consequently, private credit investments are insulated from the factors that can have a broad impact on stock prices and, in today’s investing environment, bond prices.

Leveraging rising yields 

Private credit wasn’t a common element of 401(k) accounts in the past because of the extra risk involved. Because the transactions private credit requires happen outside of public exchanges, there is less transparency. Additionally, private credit often involves lending to less established companies, which means the risk of business failure and resulting default is considerable.

In recent years, however, the high risks have been offset by the promise of high returns. In the aftermath of the 2008 financial crisis, an increase in regulation and skepticism in the banking sector made it more difficult for companies to get access to flexible and fast capital. Private credit stepped in to fill the void, taking advantage of the increased demand by raising its yields.

The pros and cons of private credit for retirement investors

The high yields that private credit can provide are definitely the top draw for placing them in a 401(k) lineup. When compared to traditional fixed-income assets in a low-yield 401(k) portfolio, private credit can offer a higher income potential for retirees.

Private credit also serves as a good hedge against inflation because private credit is generally offered with a floating interest rate that rises with interest rates. Rather than losing buying power due to rising inflation, investors who include private credit in their 401(k) can see gains as inflation increases.

In terms of cons, liquidity lockups are one of the major issues private credit investors must contend with. Traditional investment assets can be sold off rapidly to provide funds for unanticipated retirement expenses, whereas private credit is far less liquid. Those who look to their 401(k) for short-term needs are not the best candidates for private credit.

As mentioned previously. lack of transparency and default risk are also factors that must be carefully considered when exploring private credit. Risks can easily be underestimated or misunderstood due to a lack of data availability, and the types of companies that turn to private credit are often more susceptible to economic downturns.

Investors must carefully consider how the three main drawbacks of private credit — illiquidity, lack of transparency and elevated default risk — could lead to big losses. A spike in interest rates that triggers a rise in private credit defaults, for example, could leave an investor locked into an investment with no easy exit while their balance takes a hit.

Private credit investing solves two primary challenges faced by today’s 401(k) investors by providing higher yields along with a tool for diversification. But it also requires a tolerance for higher risk and operational complications. The challenge for investors is finding a way to responsibly add private credit to 401(k) accounts, with an understanding of the potential for loss and a plan in place to address any issues that may arise.

 

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