Credit tourists may feel it is time to go home

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Family offices looking for yield need to be extra vigilant as the cycle turns.

There is much about the 1970s that the world is better off not revisiting – flared trousers and three-day weeks immediately spring to mind. 

There is one 1970s fashion, however, that might be set to make a return whether investors like it or not – inflation. 

It is back to the future for many UK wealth managers and family offices: the last time their job was all about investing in government bonds and worrying about inflation was nearly 50 years ago. As the prospect of rates rising looms, this is the first time since then that protection, rather than wealth creation, is uppermost in their clients’ minds.

How will behaviour change? Their portfolios are very different today than they were then. Gone are the huge fixed income allocations to government bonds, replaced with convertibles, short-dated high yield, leveraged loans, inflation-linked and breakeven inflation-linked exposure. The move into short-dated high yield and leveraged loans has been a direct result of the reach for yield and has been funded by reducing exposure to investment grade.

Private credit

What may perhaps be of more importance is the embrace by wealth managers and family offices of private credit.

As returns have become so squeezed, many private clients have moved money out of high yield and into private credit as a more attractive source of return: private credit returns look like equity returns. Five years ago, this allocation would have formed part of the private equity allocation, but clients are now more interested in illiquid exposure because they don’t like the time horizon of private equity and want something shorter. Hedge funds used to be the answer, but that is no longer the case.

The direct lending sector, like all others, has seen a steady erosion of loan documentation and borrower quality. It is a new market and has never been through a default cycle, so potential recoveries are (pretty much) unknown.

So far, this isn’t a problem, as the economic environment has been so benign. Private credit is, however, a far less permanent capital source for corporates than the banks, so how the young sector behaves in a downturn will be crucial. 

The head of one family office that Euromoney spoke to in February admitted that his exposure to private credit was the one thing that kept him awake at night. Some wealth managers may end up regretting some of their movement away from those ultra-safe 1970s asset allocations if his worst fears do eventually come to pass.