The dawning of a new financial era: The silver lining in rising interest rates
There is much debate about whether rates will rise or fall or stay about here for some time – the latter being my personal stance and prediction. Irrespective of our own beliefs, I think we can all agree interest rates aren’t going back to the lows we saw when the U.S. Federal Reserve cut rates to zero, and our own Australian banks benefitted from the Reserve Bank of Australia’s (RBA) term funding facility, which provided three-year funding at 0.1 per cent.
It is also highly unlikely we will witness a repeat of the almost four decades of declining interest rates that so helpfully boosted the wealth of generations viz-a-vis the appreciation of all conventional asset classes, and a few unconventional ones too.
In the financial tapestry of recent decades, we’ve done nothing but revel in a climate marked by a period of generously declining interest rates followed by a prolonged period of ultra-low interest rates. Yet, today, the winds of change are upon us, hinting at a departure from this comfortable tailwind. It’s no longer far-fetched to anticipate longer periods of more modest economic growth, and narrower corporate profit margins amid a persistently higher rate of inflation. And where once a corporation might have been able to borrow ‘X’ at an interest rate of ‘i’, they can now only borrow something less than X at an interest rate higher than ‘i’. In such an environment, refinancing will be challenging for many more companies than it has been before. And in such an environment, debt will not rescue private equity ‘misadventurers’. It is, therefore, reasonable to assume an uptick in defaults, particularly amongst those ‘profitless prosperity’ companies I have written about frequently.
And while all of the above is reasonable, it is important not to become too bearish. Commentators and high-profile investors thrive off scaring the wider public. It serves them that there is always another big scary dark cloud on the horizon that everyone should be worried about. If it’s not refinancing the U.S. budget deficit, a war in Ukraine, Israel, or a possible conflict involving China and Taiwan, it’s a recession, rising interest rates and now zombie companies…again. Our industry thrives on imploring investors to look at all the dangers. As Charlie Munger once observed, “What witchdoctor ever gained fame and notoriety by prescribing two aspirin?”
Nevertheless, I don’t think it’s unreasonable to assert that we might see assets appreciating at less predictable rates and businesses wrestling a bit more for financing. Furthermore, the borrowing landscape is shifting – from the once-stable descent (over nearly forty years, I might add) to a terrain of subtle oscillations.
It’s worth emphasising that you should ignore predictions of a dramatic leap back to the sky-high interest rates of the 1980s. I think slight nudges upwards are possible as are slight nudges down. But over time, rates will, I expect, look relatively stable, settling at a generally higher plateau.
Evolving strategies in a dynamic landscape
The sunset of the golden age of investment strategies that were buoyed by the falling interest rates of the past four decades, is upon us. The 1981-2021 period was an elixir for asset owners, from corporations and private equity investors to property developers and cryptocurrency speculators. The allure of bond returns paled as discount rates took a dip, making riskier assets the darling of the financial world. And of course, the period was doubly rewarding for those who borrowed to dabble. The popularity of that latter strategy became the fuel for a boom in leveraged buyouts, debt financing of VC-backed companies, margin investing and derivatives trading.
And while investors willing to take bolder bets were reaping the rewards of a rising tide in asset prices, this same environment posed challenges for debt investors. The scramble and competition for attention-grabbing returns meant many had to decide between braving the storm with dwindling returns, dialling back the risk, or amplifying it in the hopes of higher returns. It was a time when true bargains were elusive, tucked away in the shadows of an overly competitive market.
Many a ‘risk-on’ investor might reminisce about the bounties of this era, but it’s prudent to remember the instrumental role played by the rising tide of falling interest rates, the tailwinds of cheap money.
As famed investor John Kenneth Galbraith once wryly observed,
“I think without a doubt, that what is called financial genius is merely a rising market”.
That tide, the one that lifted all boats, can be relegated to the annuls of history. It will be a period we look back on most fondly, but it will be firmly in the rearview mirror. But make no mistake; we will still have booms, bubbles and busts, but the booms might last four years, not four decades.
The coming years will paint a very different picture for asset ownership and asset class returns.
Private credit’s time in the limelight
Enter private credit. It has been growing for the last 13 years – since the GFC – but really had no time in the limelight. Until now it was an asset class before its time. But that time has now come – also helped by a cohort of baby boomers who may soon grow tired of the volatility associated with managing a portfolio entirely comprised of equities.
The present shifts in the financial milieu cast private credit in a new, much more favourable light. The ebbing tide of easy money paves the way for private credit to emerge as a bastion of stability and attractive returns. In an era of flux, the allure of consistent monthly cash income and attractive absolute returns from private credit might just be the beacon investors have been yearning for.
As we brace for a world where interest rates remain more elevated, the stage seems set for private credit investments to take their well-deserved place at the front of the line when structuring a balanced portfolio.
Table 1. Private Credit’s features and benefits
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1 |
Consistent cash flow: A primary appeal of private credit investments is the consistent cash flow they can provide. Most private loans, especially to mid-sized businesses, have regular interest payments. This is in contrast to equities, which may or may not provide dividends and can be subject to volatile price swings. |
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2 |
Secured assets: Many private credit investments are secured by tangible assets. If a borrower defaults on their loan, the lender may have a claim to certain assets as collateral. In contrast, equity investors are positioned at the bottom of the capital structure, meaning they are the last in line to receive any remaining assets in the event of bankruptcy. |
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3 |
Protection from volatility: The private credit market is less correlated with public investment market swings than equities. This means that during periods of stock market turmoil, private credit portfolios can act as a ‘cushion’, reducing the overall volatility of an investment portfolio. |
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4 |
Reliable returns: Private credit offers reliable returns based on interest rates set out in loan agreements. This contrasts with equities, where returns are highly dependent on company performance, market perception, and broader economic factors. |
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5 |
Contractual obligations: Whereas returns from equity investments depend on company performance (in the form of dividends or stock appreciation), returns from private credit returns are typically contractually obligated. Borrowers are legally required to make interest and principal payments. |
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6 |
Diversification: Incorporating private credit into a portfolio allows investors to achieve greater diversification. It’s another asset class, with a different risk and return profile compared to equities, that can work to balance out portfolio returns over time. |
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7 |
Higher yield potential: Private credit can offer higher yields than traditional bonds or other fixed-income assets, given its bespoke nature, the direct relationship between investor, manager, originator and borrower, and the link to corporate lending. |
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8 |
Direct relationship with borrowers: The direct relationship between private credit lenders or originators and borrowers, allows for more flexibility in loan terms, better monitoring of the loan, and more efficient negotiations should a borrower face financial difficulties. |
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9 |
Less competition and more opportunity for due diligence: Unlike the equity markets, which are saturated with analysts and institutional investors, the private credit space often has less competition. This may currently allow for more attractive pricing (yields and returns) and the opportunity for patient and in-depth due diligence. |
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10 |
Increasing market and maturity: Over the past decade, the private credit market has matured significantly. With this maturation comes better infrastructure, more data for making informed decisions, and a larger number of experienced participants, making it a more viable investment option for many. |
After all, in the realm of finance, it’s the blend of adaptability and vision that crafts the most enduring success stories, and private credit is an asset class whose role in portfolios will likely take more prominence.
Find out more about the Aura Private Credit Funds
You should read the relevant Product Disclosure Statement (PDS) or Information Memorandum (IM) before deciding to acquire any investment products.
Past performance is not an indicator of future performance. Returns are not guaranteed and so the value of an investment may rise or fall.
This information is provided by Montgomery Investment Management Pty Ltd (ACN 139 161 701 | AFSL 354564) (Montgomery) as authorised distributor of the Aura Core Income Fund (ARSN 658 462 652) (Fund). As authorised distributor, Montgomery is entitled to earn distribution fees paid by the investment manager and, subject to certain conditions being met, may be issued equity in the investment manager or entities associated with the investment manager.
The Aura Core Income Fund (ARSN 658 462 652)(Fund) is issued by One Managed Investment Funds Limited (ACN 117 400 987 | AFSL 297042) (OMIFL) as responsible entity for the Fund. Aura Credit Holdings Pty Ltd (ACN 656 261 200) (ACH) is the investment manager of the Fund and operates as a Corporate Authorised Representative (CAR 1297296) of Aura Capital Pty Ltd (ACN 143 700 887 | AFSL 366230).
You should obtain and carefully consider the Product Disclosure Statement (PDS) and Target Market Determination (TMD) for the Aura Core Income Fund before making any decision about whether to acquire or continue to hold an interest in the Fund. Applications for units in the Fund can only be made through the online application form. The PDS, TMD, continuous disclosure notices and relevant application form may be obtained from www.oneinvestment.com.au/auracoreincomefund or from Montgomery.
The Aura High Yield SME Fund is an unregistered managed investment scheme for wholesale clients only and is issued under an Information Memorandum by Aura Funds Management Pty Ltd (ABN 96 607 158 814, Authorised Representative No. 1233893 of Aura Capital Pty Ltd AFSL No. 366 230, ABN 48 143 700 887).
Any financial product advice given is of a general nature only. The information has been provided without taking into account the investment objectives, financial situation or needs of any particular investor. Therefore, before acting on the information contained in this report you should seek professional advice and consider whether the information is appropriate in light of your objectives, financial situation and needs.
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Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
