Introduction to private credit and public-private solutions

2.1 Getting comfortable with semi-liquidity

Getting comfortable with semi-liquidity 

 

This video outlines strategies for thinking about and communicating the risks and potential rewards of investing in semi-liquid funds like public-private solutions.

 

WKP
Wesley Phoa

Solutions portfolio manager at Capital Group

7MINVIDEO

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Liquidity vs. returns

 

Since private credit is not traded daily on public markets, it’s less liquid than public credit. Due to this decreased liquidity, as well as the credit spread, private credit tends to offer higher yields than comparable public assets.

 

The graphs below compare private credit’s annualized yield to those of core bonds and high-yield bonds. By deconstructing the components of each asset class’s yields, we can estimate the credit spread and illiquidity premium.

 

Hover over each bar below to view precise estimates for the components of each yield figure.

Navigating liquidity needs in a portfolio

 

Liquidity is a key consideration when designing a client’s portfolio. How quickly will the client need access to cash, and how much? For illiquid and semi-liquid investments, such as interval funds, knowing the answers to these questions may help avoid cash shortfalls or a bad experience when seeking to liquidate investments.

 

Semi-liquid allocation vs. spending

 

We believe that maintaining a public portfolio balance that offers income of at least three times the investor’s projected annual spending requirements is a prudent criterion for portfolio liquidity management. Starting from this baseline, the examples that follow show how feasible different levels of allocation to semi-liquid investments to the same extent (if at all) might be for an investor, based on their annual spending rate.

 

Each of the examples includes a chart of semi-liquid allocation (a semi-liquid investment is an asset that can be converted into cash more easily than illiquid investments but not as quickly as liquid investments) vs. annual spending rate, based on our simulation framework. (See the footnote for the assumptions behind these charts.)

 

Here’s how to interpret the charts:

  • The dark blue area of each chart represents combinations of semi-liquid allocations and annual spending rates that are most likely feasible for investors — in our analysis, the success criterion is satisfied by at least 95% of our simulations. The lower an investor’s spending rate, and therefore the lower their liquidity need, the more they may feasibly invest in semi-liquid funds. It is less likely that they will frequently need access to the money invested in the semi-liquid funds.
  • The light blue area represents combinations of semi-liquid allocation and annual spending that are likely infeasible — that is, the success criterion is satisfied by less than 25% of our simulations. An investor with a higher spending rate should not consider allocating to semi-liquid investments to the same extent (if at all) as an investor with lower spending. The higher-spending investor will need more of their money on demand, and semi-liquid investments make it more difficult to access that money.
  • The magenta area represents combinations between the extremes that we consider only possibly feasible. As the spending rate rises, even a low allocation to semi-liquid assets becomes markedly less feasible.

 

These charts are only a starting point for the upper bound of allocations to semi-liquid investments, not a definitive tool for every individual investor. Every investor is unique and will have personal investment preferences and constraints to consider before investing in semi-liquid assets.

Example: Equities-heavy portfolio, 2% spending rate

A man with dark hair and a light blazer leans forward in his chair.

Walter is in the middle of his career, with steady income and the following investment profile:

  • Walter expects to spend 2% of his initial portfolio balance each year.
  • He currently holds 80% global equities, 15% U.S. bonds, and 5% in semi-liquid private credit.

 

Here is a chart describing the feasibility of various levels of semi-liquid private credit investment for Walter based on his specific portfolio allocations, according to our analysis:

A graph of Walter’s annual sending rate and allocation to semi-liquid investments, color-coded by the feasibility of combinations. At low spending rates (2 to 5 percent), Walter has higher likely feasible allocations to semi-liquid assets. Allocations to semi-liquid all become less likely feasible past 6 percent spending, and likely infeasible at higher rates of both allocation and spending. The point at 2% spending and 85% allocation is labeled Point A.

In our analysis, Walter could allocate up to 85% of his portfolio to semi-liquid private credit investments (Point A) while still reasonably expecting to accommodate his 2% spending rate. This is significantly higher than his current allotment of 5% to semi-liquid private credit. Exactly how much Walter should allocate will be up to other strategic considerations, but he may have a lot of room to grow that proportion.

 

If Walter’s spending expectation increased beyond 2%, this potentially feasible proportion would be lower. At 4% spending, for example, his maximum likely feasible semi-liquid private credit allotment would be around 70%. At 8%, any semi-liquid private credit investment would become less feasible.

 

Let’s look at another hypothetical example.

Example: Approaching retirement, 4% spending rate

A woman with grey hair and a grey shirt smiles toward the camera as she leans on her desk. Her laptop is open in front of her.

Joan is approaching retirement. More of her portfolio is in fixed income, and she’s looking to generate income from her portfolio while still maintaining some growth potential. Here’s her investment profile:

  • Joan anticipates spending 4% of her initial portfolio balance each year.
  • She currently holds 50% global equities, 35% U.S. bonds, and 15% in semi-liquid private credit.

 

Here is a chart describing the feasibility of various levels of semi-liquid private credit investment for Joan, according to our analysis:

A graph of Joan’s annual sending rate and allocation to semi-liquid investments, color-coded by the feasibility of combinations. At low spending rates (2 to 5 percent), Joan has higher likely feasible allocations to semi-liquid assets. Allocations to semi-liquid all become less likely feasible past 8 percent spending, and likely infeasible at higher rates of both allocation and spending. The point at 4% spending and 75% allocation is labeled Point B. The point at 8% spending at 15% allocation is labeled Point C.


In our analysis, Joan could allocate up to 75% of her portfolio to semi-liquid private credit investments (Point B) while still reasonably expecting to accommodate her 4% spending rate. This is significantly higher than her current allotment of 15% to semi-liquid private credit. There’s potential to grow the semi-liquid, private credit allotment, if she’s interested and it would accord with her overall strategy.

 

If Joan’s spending expectation increased beyond 4%, her potential feasible proportion to semi-liquid assets would be lower. If her spending rose to 8%, for example, even her current allocation rate of 15% would be less feasible (Point C).

 

Observations

 

For each investor, raising their anticipated spending rate significantly reduces their feasible allotment to semi-liquid private credit. In both scenarios provided, semi-liquid allotment becomes less feasible at around a 6–8% annual spending rate. When planning around liquidity with your clients, it is critical to have a realistic estimate of their future spending rates.

 

Keeping all potential risks in mind, incorporating private credit into portfolios may deliver potential benefits — from enhanced yields to improved diversification. However, the success of such a strategy hinges on a tailored approach that considers your client’s liquidity needs, capacity for risk and long-term objectives.

 

Footnote

The assumptions behind these visuals are as follows:

  • Public asset classes are categorized as liquid, and private asset classes as semi-liquid.
  • An interval fund’s repurchase offer, made on a quarterly basis, is 5% to 10% of the fund’s outstanding shares.
  • Public assets form a “public portfolio” of a client account that is rebalanced to target weights on a quarterly basis.
  • Private assets form a “private portfolio” of a client account that is rebalanced to target weights on an annual basis.
  • The portfolio target weights are determined for a 60-month time horizon.
  • The spending amount is the spending rate as a percentage of the initial portfolio balance.
  • We simulated 5,000 paths using historical asset class quarterly returns from 3/31/2004 – 3/31/2024.
  • The success rate is measured as the public portfolio balance being greater than or equal to three times the annual spending rate over the simulated time horizon.

End of lesson

Using this knowledge about liquidity, you can start thinking about which of your clients might benefit from less liquid, longer-term assets. Don’t forget to review lesson takeaways here.

 

The next lesson looks at the roles that private credit products can play in a portfolio.

NEXT LESSON

Positioning public-private solutions for investors

2.1 Getting comfortable with semi-liquidity
2.2 Roles for private credit in a portfolio
2.3 Allocating to private credit for investors
2.4 Addressing concerns about private assets

Takeaway

Public-private solutions:


Liquidity and semi-liquidity

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