Last week, the Fed reaffirmed its low rate policy, now in its 8th year below 1%. The unexpected consequence of the Fed’s extended regime of low rates is that it has shattered the portfolio model of institutional investors and individual investors alike. In the next decade, the combination of a continued low yield environment and the demographic shift of 76 million baby boomers reaching retirement age will lead to a multi-faceted financial crisis of unprecedented proportions.
One of the only potential solutions will be the emerging asset class of credit alternatives in general and private debt in particular.
The “Agg”, or the Barclays U.S. Aggregate Bond, which measures a mix of government and investment-grade corporate bonds, generated an annualized total return of 7.94% between 1976 and 2013 (source: BlackRock). Most of the return was derived from steady coupon payments, and the index only generated 3 years of negative returns (1994, 1999, 2013) going back to 1976. Also during this period, the baby boomer generation (born between 1946 and 1964) consisting of the largest population cohort ever (75 million people) hit the most productive years of their working careers. Baby boomers fueled consumption and growth in both the stock market and the fixed income markets.
In the last decade, the baby boomer generation has started to reach retirement age. The number of Americans above 60 has grown dramatically and will accelerate through 2025 when the last of the boomers come of age. Between 2010 and 2025, 30MM additional people will hit 60 bringing the total 60+ population almost 90MM. Furthermore, actuarial tables 20 years ago had projected that retirement would generally last 20 years and because of health improvements, experts now believe that average retirement timelines will be closer to 30 years.
This demographic shift is occurring at exactly the wrong time to coincide with sluggish economic growth and zero rates. Under-funded pension plans are already paying out more than they take in. Individual retirees will have to find a way to generate bigger nest eggs or postpone retirement altogether.
From 2011 to 2015, the annualized total return of the Agg dropped to 2.4% – a 550 basis point difference from its historical average. Inflation has remained low and stock market returns have been robust, but since 2014, the stock and bond markets have been flat and highly volatile – the worst of all trade-offs: risk without return.
Investors need yield from somewhere new to make ends meet. But in the world of alternatives, the private debt industry is still very much in its infancy. Private debt firms have raised only $300 billion in assets under management in the U.S. relative to multi-trillion dollar alternative asset classes like private equity and hedge funds. As the demand for yield becomes more urgent from investors and institutions, private debt will become a more fundamental part of portfolio allocations. Over the next decade, private debt has the potential as an industry to scale to a level comparable with private equity and hedge funds.