Charities and credit - a love story in the making?

In the 2001 romantic comedy Bridget Jones’s Diary, Bridget has the choice between two attractive suitors; Daniel Cleaver, her grandiose and initially charming boss played by Hugh Grant, and Mark Darcy, the handsome but more dependable option. As fans of most rom coms know, the story plays out that Bridget is initially “wooed” by the allure of the exciting and often volatile Daniel, only to eventually realise that Mark was her “Mr Right” all along.

Just like Bridget, charities have traditionally invested in the higher return targeting but often more volatile asset class of equities, whilst often overlooking the appeal of the more dependable, or in this case contractual, benefits of credit markets. Whilst unlike Bridget, charities and other investors don’t need to choose one asset class or another, it’s important that trustees are aware of the benefits of credit assets when making investment strategy decisions.

The dependable choice

Credit assets (often referred to as bonds) are essentially loans made to companies or governments that investors can buy into. When investing in bonds, you’re lending money to these borrowers and, in return, they will pay you a regular interest payment (known as a coupon) as well as providing your initial investment back.

According to the 2023 Newton Charity Investment survey, the average UK Charity invests c.16% in credit assets, whilst investing c.67% in equities. Although many charities have held larger credit allocations for some time, there is an argument charities could use credit more or in different ways to enhance outcomes.

Like the stability Mark Darcy provided Bridget with, these assets provide benefits to charities. The contractual nature of the income provided by bonds provides more certainty over the range of returns investors will face, which makes planning future spending for charities easier. Equities and credit have also historically shown low correlations, meaning that if one asset falls in value, the other may not move in the same direction.

However, there is more to credit than meets the eye. Mark initially comes across to the viewer as bit dull and uninteresting and, like this initial misconception, charities can miss out on the extra underappreciated benefits of credit assets.

Overlooked benefits of investing in credit

1. High absolute yields vs recent history - After the 2008 financial crisis interest rates sat at historic lows for many years. Credit assets are sensitive to interest rate movements so low interest rates meant that the total return received from bonds was lower, and investors had to buy lower quality bonds to generate returns. Following the rapid rise in interest rates over the past few years investors are currently able to obtain a higher return (or yield) on the bonds they buy without compromising on quality. Many investors who sold bonds when yields were at lower levels may now wish to revisit the credit market to capture these attractive absolute returns.
    
2. Inflation hedging - Bonds will typically have coupon payments that are either fixed in nature (meaning you’ll receive the same coupon payment each year) or floating (meaning these coupon payments will increase or decrease as interest rates move). Fixed interest bonds, offer no inflation protection but not all credit assets have fixed coupons. When inflation rises, central banks typically increase interest rates in response, meaning coupon payments increase for floating rate bonds. Equities are often more associated with valuations increasing in line with inflation and, like Daniel Cleaver, are often the attractive choice on paper. However, like Mark Darcy, the ability of some types of bonds to hedge against inflation increases is an understated benefit that will likely tie in with many charities’ goals.
    
3. Illiquidity premium - Public credit (also known as liquid credit) refers to bonds which can be bought or sold on an exchange and easily traded by investors on a daily/weekly basis. Private credit refers to loans which are directly originated between the borrower and lender and take much longer to buy and sell, with their underlying maturities ranging from 1-10 years. Investors are compensated for locking up their money for longer in the form of higher returns and this is known as the ‘illiquidity premium’.
   
   Private credit has been a fast-growing area of credit markets in recent years, and given their long-term investment horizon, charities are well placed to capture this illiquidity premium. Lenders in the private credit space tend to have greater control over the underlying terms and conditions of the loan (also known as covenants), and most bonds in private credit funds are secured (meaning they are backed by collateral in the event the loan cannot be repaid). For investors without commitment issues, private credit provides a robust structure along with higher expected returns over the long term.
   
   There are also specific areas of private credit with attractive short-term opportunities. For example, in the coming years demand is expected to exceed supply in the real estate debt market (these are private loans taken out when buying real estate where the underlying property acts as collateral for the loan). In addition, the trend of UK pension schemes looking to sell their illiquid assets quickly to free up liquidity has resulted in high quality private credit portfolios trading at significant discounts on the secondary market.
    
4. Complexity premium - As well as being compensated for investing in illiquid assets, investors can also be compensated for buying bonds which are perceived to be more complex compared to ‘traditional’ corporate or government bonds.
   
   A good example of this is securitised bonds, otherwise known as ‘asset backed securities’ (ABS). ABS bonds take large pools of underlying collateral (made up of assets like mortgages, car loans or credit card loans) and use them to securitise a bond. ABS is often associated with the 2008 financial crisis, but in today’s environment the highly diversified pool of assets backing the loans and robust legal structures that underpin them make these assets attractive. Investors willing to overlook their unwarranted “bad boy” reputation can access this complexity premium.
   
   This complexity premium can also apply to private credit assets. Given the loans are directly originated there are complexities associated with the sourcing and underwriting of the loans, and they often require a highly specialised skillset.​​​​​​​
    
5. Sustainability - Incorporating Environmental, Social and Governance (‘ESG’) is an area of increasing focus for charities wishing to align their investment strategies with the values and beliefs of their wider stakeholders. Traditionally there has been a reliance on equities as the best way to incorporate ESG factors, but the data availability and ability of bondholders to influence borrowers in relation to ESG has improved in recent years. Credit assets are now well positioned to help trustees not only address ESG risks but to access ESG opportunities.
   
   ​​​​​​​One example of an opportunity in this space is buy and maintain credit. These funds are made up of long dated, high quality bonds which are held to maturity and provide regular cashflow to investors. These strategies have a bottom-up focus - meaning the investment manager performs detailed due diligence on each underlying loan. This approach lends itself well to the incorporation of ESG factors, and there are a range of sustainable credit funds now available to Charity investors. These funds have characteristics such as enhanced stewardship processes, underlying ESG scoring and even net zero objectives.

Choosing the right option

Charities have a broad investment landscape to explore, much like Bridget Jones's romantic choices. Unlike Bridget Jones, charities don’t just have two options when it comes to choosing the “right fit” for them. As well as there being a range of different asset classes available, in the world of credit there are many different sub-asset classes that have different return targets, risk characteristics and levels to which they meet the benefits mentioned above. For charities, its important to speak to independent investment advisors before falling head over heels about attractive opportunities.

Credit assets offer stability,  in some cases inflation protection, and additional returns through illiquidity and complexity, complementing the traditional equity route. With private credit's rise and the integration of ESG factors, bonds have become more attractive and even those investors who have previously sold credit when absolute yields were at much lower levels, may find value in giving bonds another chance.