Sometimes the best offence is a good defence

Private Credit’s correlation with traditional asset classes

The relevance of private credit to portfolio construction, and its role in delivering portfolio diversification benefits, lies in the fact that private credit performance typically moves independently from traditional asset classes. The chart below highlights the low or negative correlation of private credit to both bonds and equities.

A positive correlation of +1.0 indicates different assets will perform in tandem, whilst a negative correlation of -1.0 indicates assets will move in the opposite direction to each other. As public market assets have moved in tandem, private credit’s low correlation profile (-0.01 and 0.01 with Australian equities and government bonds respectively) provides critical diversification for the Australian investor. 

These benefits are particularly important in periods of market stress, when correlations between asset classes tends to spike higher and move into positive territory. 

Recalibrating portfolios for evolving market regimes

Private credit now stands as a critical component of a balanced portfolio of assets. Public markets have become more and more short-term in nature, with turnover rates and average holding periods rapidly declining. Sentiment swings can drastically move prices higher and lower.

This decade, the public fixed income asset class has not provided the diversification benefits that it has done in the past. This was largely the result of a cocktail of low yields, high inflation, and rising interest rates. 

Total returns from fixed income have been poor since 2017, while high inflation has meant that the average real fixed income return has been negative (i.e. the return adjusted for inflation).

Adjusting defensive allocations for current and future markets

Since 2017, the Metrics Master Income Trust (ASX: MXT) has produced superior returns with lower volatility. Its low correlation profile to both Australian equities and bonds, has provided critical diversification for those investors seeking attractive risk-adjusted returns.

Private credit’s diversification benefits stem from three structural factors:

1. Lower volatility: Unlike public fixed income, private credit valuations reflect contractual cash flows rather than daily changes in the views on the direction of interest rates and overall market sentiment swings.
2. Borrower-Lender Alignment: Direct lending agreements include covenants, controls and collateralisation absent in public markets, decoupling the investment from the heavy impact of broader macroeconomic drivers seen with public bonds.
3. Economic sensitivity: Metrics Credit Partners lends to large-scale corporates who are less impacted by the economic cycle. According to ASIC Corporate Insolvency Statistics for FY24, over 99% of insolvencies were from businesses with $10M or less in assets - small businesses that Metrics does not lend to.

Empirical validation comes from the 2022–2024 rate hike cycle, where Australian private credit maintained 6–8% net returns despite 15% declines in composite bond indices, demonstrating negative beta to duration risk.

An opportunity to modernise the 60/40 portfolio

While many investors may focus on the ability of private credit to diversify and lower overall risk within their portfolios, the ability of the asset class to meaningfully enhance returns cannot be overlooked. The long-term nature of many private credit investments makes their potentially enhanced return profile even more appealing to Australian investors. 

Additionally, as private credit investments are unlisted, short term ‘mark-to-market’ valuation volatility within a portfolio, likely during periods of market stress with listed investments, is less of a concern.

Private credit now rightfully stands as a long-term strategic allocation within a balanced portfolio of investments, and one that is likely to continue to provide important diversification and return benefits in the years ahead.

In times of market stress and uncertainty, sometimes the best offence is a good defence.