The (sometimes lonely) case for public credit

By Jeffrey Berman

Private credit has become a core, and likely permanent, component of insurer general accounts. With it now firmly established as a key investment tool, is public credit now the “alternative” asset class that warrants more focus?

Private credit makes sense

Private debt has grown exponentially with the evolution of bank financing regulations, and a (now gone) low-yield environment that helped jump-start the sector’s growth.

Insurers are natural owners of private debt. Yield-oriented buyers need constant origination sources, have less need for liquidity and have a self-fulfilling industry dynamic to stay competitive on new underwriting, particularly those with private equity backed ownership models.

But with Moody’s reporting one-third of U.S. life insurers’ assets (or around $2 trillion) now in private debt, do the tradeoffs of private credit relative to public credit start to warrant further consideration in the asset allocation mix?

At some point, liability mismatch risk could start to creep in, as a significant part of the private credit universe has weighted-average lives shorter than the typical life liability but longer than the typical property/casualty liability.

Credit risk could also start to creep up, as JP Morgan announced in August that 60% of leveraged buyouts were funded in the private credit market last year, while Bloomberg noted a trend of lower-rated issuers using private credit to refinance outstanding public credit.

Valuations may become less appealing as further demand for private credit is fueled by retail segments, the growth of business development companies, new access vehicles (such as exchange-traded funds) and defined contribution retirement plans.

In short, valuation, due diligence and structuring risks may be increasing.

Bonds can offer yield, liquidity, diversification and flexibility

Absolute public credit yields remain historically attractive, even with the Federal Reserve cutting rates. Meanwhile, private credit’s Illiquidity premium has compressed, making relative yield considerations less significant.

Bonds offer exposure across the credit universe, including to well-capitalized companies that are leading in the new economy.

Bonds also offer the potential to more precisely match against liabilities, the liquidity to meet unexpected needs, participate in opportunistic market events, and deploy illiquidity budgets in other private market sectors.

We believe the opportunity set in bonds is attractive, notably in nontraditional asset-backed securities, global bonds and diversified high yield.

A nontraditional or “esoteric” ABS allocation can be viewed as a “cousin” of private credit. One of the faster growing areas of the nontraditional credit market, this sector offers exposure to uniquely structured and well-collateralized investment grade debt at current spreads 50-300 basis points higher than comparably rated corporate credit.

This sector can include bonds backed by data centers, music royalties and receivables, among other idiosyncratic sectors. It can offer many of the advantages of private credit but in a format compatible with the National Association of Insurance Commissioners’ capital efficient framework, with greater liquidity and transparency, at a fraction of the fees of private credit.

The current rate and currency environment may make global bonds attractive, with currency-hedged investment grade average yields at 6%-8%.

Evolution in trading and access to other sectors opens additional opportunities. For example, basket trading in below-investment-grade bonds can turn a once less liquid and more concentrated sector allocation into the most diversified and liquid component of a portfolio, with high yields.