Higher yields without higher credit risk. These are two attractive attributes of well selected private-debt issues, investment experts say. Yet few retail investors have access to private debt. It's a segment of the fixed-income market, of unknown size, that is almost entirely the domain of institutional investors.
In giving individuals at least a little exposure to private debt, an exception among fund managers is TD Asset Management Inc. "Holding private debt in a retail fund can offer traditional bond investors the potential to enhance portfolio yield and diversification without sacrificing credit quality," says Marc Rouleau, a vice-president and director at TDAM.
As Rouleau explains, private debt may offer higher yields than publicly traded bonds with comparable credit risk, based on TDAM's internal credit rating for the private debt. Institutional investors like TDAM can obtain a yield premium to reward them for investing in a debt issue that is more complex and less liquid than a traditional public bond.
"This premium can vary depending on the level of complexity of the private-debt security," says Rouleau. "Generally speaking, the more tailored or unique the transaction, the higher the premium."
Bruce MacKinnon, who leads the TDAM team responsible for global investments in private debt, cites yield enhancement, safety and diversification as the three distinct benefits of private-debt issues that meet TDAM's credit-risk criteria. He estimates the yield pick-up for private debt to be 50 to 150 basis points over that of investment-grade corporate issues of comparable credit quality.
In terms of safety, TDAM officials say, a properly structured private-debt investment may include covenants that provide greater security than an unsecured publicly traded bond. Also, private-debt securities tend to make partial principal payments, along with interest payouts, before the maturity date. This differentiates them from public bonds which repay the principal amount only at maturity.
As for diversification, private debt enables money managers to obtain exposure to issuers that may not be included in debt-market indexes, and to sectors that may be underrepresented in the public markets. "Private debt makes a good complement to your existing fixed-income portfolio," says MacKinnon, who spoke to an audience of institutional investors in Toronto on April 20.
For all these positives, and the expertise that TDAM has devoted to analyzing private debt, these securities play only a very minor role in its retail fixed-income funds. Though securities regulations limit prospectus-offered mutual funds to holding no more than 10% of their assets in illiquid holdings such as private debt, TDAM's internal limit for private debt is a much stricter 3% of assets at the time of purchase.
In practice, TDAM has kept well within its investment-policy limit. For example, at the end of 2016, the several private-debt holdings of TD Corporate Bond Plus represented a combined total of a mere 1% of fund assets. As of April 30, private-debt holdings had risen to 1.5% of assets, or only half of TDAM's internal limit. TDAM provided these percentages to Morningstar; in the annual report, private-debt holdings aren't grouped separately and aren't readily identifiable.
In TD High Yield Bond, which focuses on non-investment-grade securities, there are no private-debt holdings whatsoever. The reason for their absence is that TDAM restricts private-debt investment to investment-grade equivalent only, based on its internal rating analysis as determined by its credit-research team. "Thus, we do not see a role for these investments in TD High Yield," Rouleau says.
High-net-worth investors who are comfortable with holding private debt can obtain a much more meaningful exposure, says Dan Hallett, a vice-president and principal with HighView Financial Group, an investment-counselling firm in Ontario.
Assuming that holding private debt is consistent with investment objectives, risk tolerance and liquidity requirements, "a 10% allocation seems about right" for some clients, Hallett says.
For its clientele, HighView has taken a diversified approach by offering four different private-debt securities as a package. Subscribers, who require a multi-year commitment, get exposure to a combination of mortgage loans, asset-based lending, specialty financing and privately issued preferred securities.
Hallett estimates that a portfolio of high-quality private-debt securities can provide a yield in the 4% range, or about double that of the public universe of Canadian investment-grade bonds consisting of both government and corporate issues. "The real range (of yield pick-up) goes quite a bit higher," says Hallett, "once you start taking some meaningful credit risk."
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