What maximum proportion of your portfolio could be in private credit? – 06/04/2023 – From Grain to Grain

The term private credit makes many people shudder. On several occasions, those who widen their eyes have more private credit than they realize. Recent events end up raising the fear of investors who wonder what would be the maximum to have private credit in a portfolio.

As I wrote earlier, the three most frequent questions I receive from investors are related to three factors: profitability, taxes and issuer. I’ve talked about the first two factors in past articles. Now, I will comment on the issue of the emitter.

When talking about fixed income, the issuer can be public or private. When talking about a private issuer, we are talking about federal public bonds. There is only one issuer in this case, so the credit risk for all securities with this feature is the same.

Investors often confuse that, for private issuers, there would also be a certain uniformity. But it’s not the case. Hence the uncertainty of how much private credit (PC) in the portfolio would be inappropriate.

Private credit fixed income security risk is not the same for all cases.

For example, I bet that many readers have 100% of their portfolio in CDBs, LCIs or LCAs from Banco do Brasil, Bradesco, CEF, Itaú or Santander. These are the five largest banks in Brazil, in alphabetical order.

These investors have 100% of their portfolios in private credit.

Yes, there is some risk if the amount invested exceeds BRL 250,000 by each of these issuers, as this is the limit of the Credit Guarantee Fund (FGC). However, the risk is fairly low on these issuers.

So, if you do that, you would undoubtedly be missing out on higher return opportunities, but you would not be with inadequate risk exposure.

You can also divide a portfolio of BRL 1 million into CDBs, LCIs or LCAs of five or more medium-sized bank issuers and increase your return by 10% to 20% of what you would earn at the large banks mentioned above.

Even in this case, this investor would also have a low risk. A fairly conservative applicator could do this.

If you invest in bank bonds, within the FGC guarantee limit, depending on the size of your portfolio, you could have up to 100% invested and the risk would be classified as low.

Therefore, it is wrong to think that having 100% of the portfolio in CP is always inappropriate. It depends on the guarantees you have.

The risk in the CP begins to appear when moving to issues without the FGC guarantee. In this case, you have to be very careful.

Two simple rules need to be adopted: spraying and quality.

If you spread out the portfolio with close to 1% of the portfolio exposure per issuer and only in high quality issuers with collateral attached, you could have up to 100% exposure to private credit. In this case, the ideal would be for at least part of these exposures to be via investment funds so that you can count on professionals in the selection and monitoring of assets.

Undoubtedly, by doing this, you would be taking more risks than investing in bank bonds alone. However, it could have higher returns.

For example, while a five-year government bond yields IPCA+5.8% pa, you could earn up to IPCA+7% pa on CDBs. As for private bonds issued by high-quality companies, you could earn the same IPCA+7% pa, but exempt from income tax.

A title exempt from IR that yields IPCA+7% per annum is equivalent to a taxed title with a yield of IPCA+9% per annum. That is, it is equivalent to a premium of 3% per year above the public bond.

Therefore, there is a private bond premium that can be interesting if taken cautiously.

Thus, the maximum proportion that could invest in CP from its portfolio should be in line with existing collateral, quality of issuers and possible dispersion. When I talk about guarantees, I am referring to the FGC and types of corporate credit guarantees.

The most appropriate thing is to have a diversification between the two private credit issuers, that is, the bank with FGC guarantee and the private issuer without this guarantee, but of high quality and with dispersion. If you do this balancing, you can have up to 100% of your portfolio in these investments and enjoy better returns. However, you need to follow the safety rules.

Michael Viriato is an investment advisor and founding partner of Investor House.

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