What Is Private Debt and Why Is It So Appealing to Investors?

One form of alternative investment that has gained a lot of traction in recent years is private debt. The category of private debt includes any debt held by or awarded to private companies. Everything from hedge funds and high-yield bonds to established companies obtaining loans from non-bank lenders fall under the umbrella of private debt.  

Some of the most common forms of private debt include corporate bonds, hedge funds, and non-bank loans. Importantly, private debt is not the same as private equity—the latter implies some degree of ownership in the company. Instead, private debt generates a return for investors through interest paid on the principal. Here’s what you need to know about private debt and what makes it so appealing to investors: 

The Size of the Private Debt Market 

Currently, private debt accounts for up to 15 percent of all assets held by private investors. This makes sense considering that the majority of companies have some form of debt. The amount of private debt in the market has increased, in part due to the Global Financial Crisis in 2008. Even before that time, many companies struggled to secure traditional loans.  

The crisis made the situation even more difficult, and now companies without an established credit history will generally seek out alternative forms of debt. Even as the market has improved since 2008, banks have not become more welcoming to smaller businesses or even medium-sized ones for fear that history will repeat itself. 

At the same time, investors demonstrated commitment to the debt market, with $60 billion in alternative lending in 2007 and 2008 alone. Assets in private debt reached a record high in 2019 of $812 billion. Market analysts believed assets would surpass $1 trillion by 2020, although the COVID-19 pandemic caused this target to be missed. In 2019, the number of total asset managers reached a record number that was double the total from only five years prior. All of this has created a rich ecosystem of private debt, with investors continuing to be drawn to the market and more money being funneled into private loans. 

The Attraction of Private Debt for Investors 

Private debt has numerous benefits for investors, which is why they continue to explore the market. One of the main benefits is diversification—with an asset that protects against rising interest rates. This is because unlike other fixed income securities, these assets often have floating rates.  

As a result, private debt offers reliable income that has the potential to increase if interest rates rise. Also, many investors use private debt as a means of getting exposure to sectors that would otherwise prove difficult, such as renewable energy. For many investors, private debt is the ideal way to achieve diversification while keeping risk within acceptable limits. 

The other major benefit is the rate of return, which is typically higher than what is available in the public debt market. This is especially appealing for investors since private debt is often more liquid than public debt. Interest income is usually paid out quarterly to create cash flow, and there is a rich secondary market for these debts.  

Private debt has traditionally been considered illiquid, but this is not necessarily the case, especially as new structures with flexible terms make them even more appealing for both borrowers and investors. Altogether, these investments have lower risk and high yields while promoting overall diversification. 

The Effect of the Pandemic on Private Lending 

The COVID-19 pandemic has had a dramatic impact on all asset classes, including private debt. The overall market has still not recovered fully, but the impact of the pandemic may actually benefit the private debt market. This is because middle market companies fighting to survive in the period of market recovery are turning to private debt frequently.  

In other words, the turbulent landscape created by the pandemic has created new opportunities in private debt for investors. Overall, this shift has resulted in higher returns and more liquidity for investors. Furthermore, companies have become more likely to look for investors that can provide strategic guidance in addition to funding. With this additional support, there is greater likelihood that the company will survive and that the investor will continue to receive interest payments. 

During the period of recovery, the overall volume of deals may decrease since terms will be stricter and rates may be higher. However, there is also the expectation that more due diligence and transparency, as well as an earlier discussion about rates, will ultimately result in better loan terms for investors. Banks have once again become more cautious about the loans that they make, which means that private debt will be the only option for many companies that need capital. All of this means the market may again experience a boost, especially as the threat of a recession looms and banks become even more conservative. 

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3 Strategies for Mitigating Currency Risk with International Investments

While investing in international assets provides great diversification for your portfolio, it also comes with risks, from country risk to currency risk. While some foreign securities may be issued in your native currency, the likelihood that all are is low. As long as some assets in your portfolio are issued in a foreign currency, you are exposed to currency risk. This is the risk associated with the value of currencies relative to each other. The exchange rate may change in such a way that your foreign assets are suddenly worth more, or the shift could sharply limit the returns from your investment. Many investors simply accept currency risk and hope that their returns are not negatively affected. However, there are also ways to mitigate this risk.

1. Using Exchange-Traded Funds to Hedge Currency Risk

One strategy for hedging currency risk involves exchange-traded funds (ETFs). You will find ETFs that offer both long and short exposures to most currencies. The funds are a basket of investments that include currency positions which will gain or lose according to changes in the exchange rate. You can use these funds to balance the position you have with your existing investments. For example, if you invest in a security issued in euros, you could also purchase an ETF that works inversely to the value of the euro relative to your currency. In other words, if you invest in something that will lose money if the euro loses value, then you could also invest in an ETF that gains when the euro loses value. However, this hedge could also reduce any gains you would see if the euro ended up increasing in value.

There are several limitations to trying to hedge in this way. First, you need to find an ETF with the appropriate exposure that has investments you feel comfortable with. Then, you need to be able to invest in that ETF in a way that matches your exposure to the foreign currency 1 to 1. Also, you must know that the mechanics of the fund may not make it operate as intended all the time, which means that some risk remains. Furthermore, ETFs based on currency tend to be among the most expensive and can charge high fees, which eats into your gains.

2. Using Currency Forward Contracts to Mitigate Currency Risk

You can also consider currency forward contracts to mitigate currency risk. These contracts are essentially an agreement to buy or sell a currency at a certain exchange rate and a specific time in the future. With a forward, you can lock into a specific exchange rate for a currency. In general, you will need to put a deposit down with a currency broker to purchase a forward contract. This makes the most sense when you plan to hold foreign assets for a specific amount of time. You can purchase a forward to lock in your conversion rate at the time you expect to sell, which reduces the risk you face in this situation. Of course, this can always work against you if the exchange rate moves in such a way that you would actually gain through the conversion since you are locked into a different conversion rate. 

The above scenario is the biggest risk with currency forward contracts. In general, you should only lock into this contract if you expect that the conversion rate will move in a way that does not favor you or if you need to eliminate this variability from the equation. You will also need to find another party willing to enter the forward contract with you. Depending on the current political situation, this could be quite difficult, and you may need to accept a different exchange rate than you wanted to get the contract. 

3. Using Currency Options to Reduce Currency Risk

The third option you have for controlling currency risk is a currency option. An option gives you the right but not the obligation to sell a currency at a specific rate on a predetermined date. These contracts do not force a sale like forward contracts. 

However, you will need to pay a premium for this convenience. The premium is an upfront fee for the contract. With an option, you can choose not to do the exchange if the conversion rate changes in such a way that you gain value. Remember that this deal is only worth it if the premium is less than the amount that you gain with the change in conversion rate. The premium is lost money, so an option only makes sense if you think that the conversion rate could change enough to make it worth it.

Of all the strategies listed, options are the riskiest since they require you to make an international investment that earns a gain, and you can forecast the exchange rates to the point that it covers the premium. In certain situations, options can earn you an incredible amount of money. However, if you misjudge, you could also lose out on considerable money depending on the price of the premium. Since these premiums can easily be thousands of dollars, it is important to balance risk when purchasing a currency option. 

Should Structured Products Be a Part of Your Investment Portfolio?

Alternative investments include assets outside the traditional classes of equities and bonds. Structured products are one of the most complex investments in this category. This investment is particularly challenging to understand fully because it is a customized mix of other assets meant to meet specific investor needs. Often, structured products include the use of derivatives.  

Investment banks created structured products for a wide range of customers, including hedge funds, organizational clients, and individuals. When creating these products, specific goals and needs are weighed to make a custom investment for the client. 

What Exactly Is a Structured Product? 

Structured products can vary greatly in terms of scope and complexity depending on the expectations of the client and overall risk tolerance. In general, a structured product will expose you to fixed income markets and derivatives. Typical structured products will start with a traditional security like a certificate of deposit or investment-grade bond. Then, the usual payment features are replaced with new types of payoffs that depend on the performance of underlying assets rather than the cash flow of the issuing party. A very simple structured product, for example, may be a certificate of deposit that does not have interest payments but instead pays yearly based on the performance of a particular stock index. If that stock index rises, the investor earns money. If it falls, the investor still gets back the initial investment when the certificate of deposit ends. 

Investors are attracted to structured products because they can offer exposure to different markets and drive diversification. For example, a rainbow note is a structured product that exposes investors to more than one underlying asset. Rainbow notes can derive value from assets that are not very related to each other, such as indexes in different countries or that follow different types of investments. This can reduce volatility since diversification is built into the investment itself, especially if it has a lookback feature. With this feature, structured products use the optimal value of an underlying asset over a certain period rather than the final value at expiration. However, these types of structured products can become extremely complex. 

The Benefits and Drawbacks of Structured Products 

The primary advantage of a structured product is the diversification it offers, which is much more than you get with a typical asset. The other benefits of these products typically depend on the exact type of investment, as they vary so much. However, depending on your needs, you can protect your initial principal, minimize tax burden, lower overall volatility, or maximize returns when compared to the underlying assets. In addition, these products can be used to generate positive yields when the overall market is not performing well. While one product would not provide all of these benefits, you can choose what means the most to you based on your goals and your existing portfolio.  

While the advantages of a structured product can be exciting, the drawbacks are significant. One of the biggest is the complexity of the product, which can expose you to risks you do not even realize. Beginning in 2018, the Securities and Exchange Commission has been stricter with structured products due to a lack of transparency. That same year, a major firm paid out $4 million after it was found that representatives were encouraging investors to buy and sell a structured product intended to be held until maturity. In turn, these representatives earned huge commissions while investor returns were reduced. The increased scrutiny has improved the environment, but investors still need to recognize that there is risk in the complexity of these products.  

Beyond that major disadvantage, the fees associated with structured products can be very high. Furthermore, these fees can be hidden within the payout structure of the investment or in the charges associated with entering and exiting positions. In other words, you may not even realize how much you are paying. Plus, there is some credit risk with the bank backing the structured product. Issues with this bank could affect your payout. You may also struggle to sell the product if you want to exit before maturity, so they are not a great option if you need liquidity.  

The Bottom Line 

Structured products can provide a unique sort of diversification for investors and offer many other advantages depending on individual needs. However, you will likely pay high fees for these advantages. Because these products can get very complex, it is important to read the fine print and understand exactly what the investment entails. You may need some professional assistance clarifying points about it. Some banks use structured products primarily as a way to drive profits, so it is important to approach these investments with some healthy skepticism and do your homework before investing. 

Want to Invest in Foreign Markets? Consider These Options

Investing in foreign markets can provide several benefits. These markets typically offer excellent growth potential while additionally giving your portfolio some diversification. The factors that impact your domestic market do not necessarily have the same dramatic effect on international ones, and this can provide some protection for your investment.

Of course, international markets also come with considerable risk in terms of volatility. In addition, you need to consider geopolitical risk and the overall stability of the global and regional economy, as well as potential lack of regulation. Still, many advisors recommend at least some exposure to foreign markets in your portfolio. Once you decide to invest in foreign markets, you have several options for making your entry. Some common ways of investing in foreign markets include:

Foreign direct investing:

As an investor, you can purchase foreign stocks directly by opening a global brokerage account in your home country or by opening one with a broker in the target country. However, direct investing involves additional costs, currency conversion, greater technical support needs, and complex tax implications. Casual investors generally avoid this option because of the complications involved.

In addition, there is always the risk of engaging with a fraudulent broker in the target market, especially if there is no reliable regulatory body there. If you choose to go this route, make sure to do your research and learn as much as you can, not just about the particular stock, but also the market and its regulations. Other options exist if this seems like too much work.

American Depository Receipts (ADRs):

Many foreign companies will use ADRs to establish some presence in the American market. Some ADRs also help companies raise money. Depending on the ADR, trading happens on a national exchange or over the counter. The ADRs represent underlying shares of the company in a different market. Always read the fine print, since one ADR may actually represent more than one share of the company.

ADRs are traded just like any other American stock, so they are convenient for many investors as they cut down on the confusion involved with investing in a new market. Plus, they are traded in American dollars and come with some degree of protection from regulatory bodies.

Global Depository Receipts (GDRs):

GDRs are similar to ADRs, but are usually issued in European markets. This makes them more accessible to European investors than even ADRs. Still, many GDRs are listed in American dollars. However, British pounds and euros are also used for denominations. GDRs are traded just like domestic stocks in their particular market. Most often, you will find GDRs on the London Stock Exchange or exchanges in Frankfurt, Dubai, and Singapore. For the most part, GDRs go to institutional investors in private offerings before they hit the public markets. Make sure you understand regulations in the specific GDR market you’re interested in before you invest.

Exchange-Traded Funds (ETFs):

Many people access foreign markets through international ETFs because they provide exposure to a range of investments and save you the trouble of choosing your own. Some international ETFs have exposure to several different markets while others will focus on just one country. The funds can be based on sector, region, market capitalization, investment style, and other categories. Many different prominent international ETFs have emerged. Before you invest in any ETF, make sure to look closely at the fees, trading volumes, tax ramifications, and liquidity. You should also pay close attention to the portfolio holdings to make sure they align with your goals and ethics.

Mutual Funds:

Mutual funds are another good option if you don’t want to do a lot of your own homework as you invest in foreign markets. Many mutual funds now focus on international equities. By investing in one mutual fund, you get exposure to a much wider range of investments. However, you will still need to select the right fund for your portfolio and risk tolerance, as some can be quite aggressive while others are rather conservative. Funds may focus on a specific country or region. Some funds are designed in a passive manner to track a foreign stock index, while others are much more actively managed. Funds with active management will charge higher fees. In addition, global mutual funds in general have higher fees than domestic ones, simply because of the higher costs of international investing.

Multinational companies:

Some investors may not be comfortable with foreign investment even through ADRs, GDRs, and mutual funds because of the risks involved. If you fall into this category, you can still gain some exposure to foreign markets through multinational corporations. Look for stocks from companies that derive a significant amount of their sales from overseas. While this is not true international diversification, multinationals may be affected by different pressures from domestic companies, and so they may offer some protection from factors impacting domestic markets. If you choose this route, be sure to keep tabs on the company and how it develops internationally as this will affect how it performs in the future.