Kristofer Kraus, Portfolio Manager, PIMCO
Join portfolio manager Kris Kraus as he walks through the rapidly growing specialty finance market and the compelling investment opportunities it offers within private credit.
Private credit has gained significant traction since the 2008 global financial crisis (GFC), as regulatory and accounting changes led traditional banks to scale back lending. This pullback has opened the door for alternative, non-bank lenders to step in. Private credit, primarily involving corporate loans not traded on public exchanges, has attracted investors with its potential for diversification, income generation, reduced volatility, and superior returns compared to public markets.
A rapidly growing segment of this space is specialty finance, which focuses on non-corporate markets such as consumer loans, equipment leasing, and aviation finance, offering significant and important diversification to traditional private credit exposure.
Largely consisting of portfolios of consumer credit, specialty finance contrasts with corporate direct lending, where the success of the investment hinges on a single large borrower. Specialty finance also tends to involve shorter durations, usually around two years compared to the four to seven years typical of private credit, with payments coming through monthly or quarterly, including both principal and interest.
While the return profile for specialty finance can exceed that of corporate lending, with potentially lower volatility. Expected returns can start in the high single digits and reach the mid-to high-teens for clients with higher risk appetites, given today's base interest rates.
But successful specialty finance investments require a granular understanding of the consumer and their financial health. At PIMCO, we maintain a comprehensive database covering approximately 10% of the U.S. population, across auto loans, credit cards, mortgages, and student loans, among others. This database, which spans over 20 years, provides about 200 million loan-level data points monthly, giving PIMCO a unique edge in analyzing consumer credit markets.
We believe robust data infrastructure and analytics gives PIMCO an edge when it comes to unpacking and identifying which investments will outperform in different economic cycles, especially in a recessionary environment. It helps PIMCO identify pockets of value in consumer-related assets, including residential mortgages, home improvement, solar and student loans, or unsecured consumer loans and credit card receivables.
Gaining momentum
Historically, economies have relied on banks as the main source of credit for individuals, corporations, and governments. That changed dramatically with the GFC, with the resulting regulations aimed at shifting risk away from the banking system. As banks pulled back from lending, non-bank lenders stepped in as capital providers – and in many ways are better suited to holding this risk than traditional banks that are funded by retail deposits. As a result, the growth of non-bank lending is gaining momentum.
The evolution of private credit has also expanded its definition, evolving from being almost exclusively about corporate direct lending, to include several different areas of opportunities that fall under that umbrella, including specialty finance.
While corporate direct lending remains the core private credit allocation for many investors, adding exposure to specialty finance can be complementary, given its distinct risk-return profile. It offers significant diversification away from the corporate exposures many investors already hold, and also provides a strong income component that begins de-risking the investment from the start.
All investments contain risk and may lose value. Investments in residential/commercial mortgage loans and commercial real estate debt are subject to risks that include prepayment, delinquency, foreclosure, risks of loss, servicing risks and adverse regulatory developments, which risks may be heightened in the case of non-performing loans. Private credit involves an investment in non-publically traded securities which may be subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Private Credit will also be subject to real estate-related risks, which include new regulatory or legislative developments, the attractiveness and location of properties, the financial condition of tenants, potential liability under environmental and other laws, as well as natural disasters and other factors.
This material contains the current opinions of the manager and such opinions are subject to change without notice. This material is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
PIMCO Europe Ltd (Company No. 2604517, 11 Baker Street, London W1U 3AH, United Kingdom) is authorised and regulated by the Financial Conduct Authority (FCA) (12 Endeavour Square, London E20 1JN) in the UK. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser. Since PIMCO Europe Ltd services and products are provided exclusively to professional clients, the appropriateness of such is always affirmed.
