Private credit is a growing retirement income strategy

Companies seeking loans and investors seeking income have complementary goals. Direct lending and alternative investment are where those interests meet. Companies get lower-fuss access to cash; investors earn interest often higher than what other income investments provide.

Put another way, companies pay more for speed or accommodative lending standards while investors earn more for carrying a higher level of risk.

“Selling assets to fund daily lifestyle needs can feel a little fraught,” said Wilma Burdis, a director of Raymond James Equity Research who covers asset management companies. “Many investors have found they prefer the regularity of income but want to see potentially better returns than traditional income strategies. If they have a higher tolerance for risk, or I should say a different tolerance for risk, direct lending can be that answer for that slice of their portfolios.”

On the other side of the ledger, direct lending has become an important way for mid-size companies to get credit, particularly those owned by private equity companies that tend to run higher debt ratios.

The private credit market in the US is estimated at around $1.5 trillion to $2 trillion, with direct lending comprising a third to a half of that. Comparatively, the public corporate bond market is about $12 trillion.

“The number of individual investors with direct lending as part of their portfolios has grown rapidly, on a percentage basis, but in total numbers market penetration remains low,” Burdis said. “That could change, particularly as the industry continues to make these investments easier to enter and investors continue to look for opportunities differentiated from macro trends.”

Investing in direct lending

Individual investors access the direct lending market through vehicles called business development companies, or BDCs. BDCs act in some ways like loan officers, performing due diligence and extending credit. In other ways, they are like investment fund managers, shaping the fund’s exposures to different parts of the economy. The most popular BDCs tend to cast wide, diversified nets, with BDCs loaning to hundreds of different companies.

Shares of some BDC funds are traded on public exchanges and bought and sold like stocks or exchange-traded funds (ETFs). Non-traded BDCs are marketed directly to brokerages, financial advisors and individual investors. A typical minimum investment is $25,000 with additions possible in $10,000 chunks.

As long as a BDC pays out at least 90% of earnings to investors, investors’ earnings are reported on Form 1099-DIV. This makes BDCs attractive to investors looking for a simpler tax reporting process compared to Form K-1, which may be required for other types of private market investing.

Highlights on risk

• Credit risk: Borrowers could default on loans, which would negatively affect returns.
• Manager risk: The efficacy of a BDC relies on the skill of its manager.
• Investment risk: Shares in traded BDCs can lose value. Both traded and non-traded BDCs may keep a portion of their portfolios in non-credit investments, like stocks, which can also lose value.
• Interest rate risk: BDC loans are issued at floating interest rates: a reference rate (commonly the Secured Overnight Financing Rate) plus a risk premium. If the benchmark rate falls, investors’ yields would decrease.

Traded versus non-traded BDCs

Beyond how shares are bought and sold, traded and non-traded BDCs have some distinct differences:

Funding – Traded BDCs are closed-end funds, meaning they raise all the money they intend to loan by selling shares at an initial public offering. When the loans are paid off, the fund closes. Non-traded BDCs can run continuously.

Liquidity – Traded BDCs are considered liquid investments, since shares are bought and sold like stocks on a public exchange.

Non-traded BDCs are illiquid, as redeeming shares can take weeks or even quarters or more, depending on the BDC’s redemption rules, which are designed to protect the integrity of the company. Like many other private market investments, some BDCs require investors commit to a minimum amount of time.

Share price – The total price of all shares of a traded BDC can diverge from the value of all assets owned by the BDC, known as its net asset value. This means shares can be priced at a premium or a discount. Shares in non-traded BDCs are created when an investor enters the pool and redeemed when an investor exits, so shares are intrinsically tied to the net asset value.

Versus other common income strategies

Fees – BDCs are complex businesses with significant labor demands. As a result, BDC investment fees tend to be higher than common income investment vehicles like ETFs or mutual funds. Annualized fees above 2.0% are typical.

Growth – Shares in a traded BDC can increase in value, but non-traded BDCs are pure income strategies. Unlike dividend equity or fixed-income strategies where one may hope underlying assets will grow in value while they pay income, non-traded BDCs have no such growth component.

Yields – In addition to generally offering higher yields than other types of income investments, BDCs issue loans based on floating interest rates plus a premium, meaning that if the fund’s benchmark interest rate increases, or decreases, yields change equivalently.

Determining whether direct lending is right for you

ETFs and mutual funds that blend many corporate and government bonds are the most common fixed-income vehicles today. However, more than a decade of strong stock performance has left some investors wondering if they’ve overvalued safety, particularly investors whose significant wealth gives them a naturally higher tolerance for risk.

Direct lending may bridge the gap, providing the convenience of regular income with a risk-to-reward consideration between traditional fixed-income and equity growth strategies. And if you’re looking to diversify your income streams away from public market trends, direct lending could be one way to do it.

This material is for informational purposes only and is not a recommendation. You should discuss this strategy with your financial advisor before investing. Alternative investments, such as private credit, involve specific risks that may be greater than those associated with traditional investments and may be offered only to clients who meet specific suitability requirements, including minimum net worth tests. You should consider the special risks with alternative investments including limited liquidity, tax considerations, incentive fee structures, potentially speculative investment strategies, and different regulatory and reporting requirements. You should only invest in hedge funds, managed futures or other similar strategies if you do not require a liquid investment and can bear the risk of substantial losses. There can be no assurance that any investment will meet its performance objectives or that substantial losses will be avoided.