You know fixed-income investors are in trouble when 10-year U.S. Treasuries yielding roughly 1.75% are considered one of the best deals in town, or in this case, the world in terms of providing a safe, positive yield among sovereign debt. As the negative-interest-rate club expands around the globe and slowing economic growth is pressuring central banks to keep slashing interest rates and/or prolonging quantitative easing to prime the economic pump, it’s suppressing yields across a swath of fixed-income vehicles people formerly counted on for retirement income.
Desperate times call for creative measures when looking for yield. Like, for example, private credit comprising debt-like instruments that don’t trade in the public markets and typically are provided by non-bank entities to fund middle-market companies. This is a variegated space that includes collateralized loan obligations, mezzanine loans and other options. These are typically riskier and higher yielding than traditional debt instruments.
This realm is the focus of the Virtus Private Credit Strategy ETF (VPC), a U.S.-centric product whose underlying Indxx Private Credit Index has 64 holdings divided roughly between two-thirds business development companies (BDCs) and one-third closed-end funds with a private credit focus.
As of August 30, this fund had a whopping distribution yield of 13.52%. Here’s why:
BDCs generally are private-equity firms that invest in, or lend to, private small to midsize companies via equity investments and debt securities—predominantly the latter. These debt securities can range from senior secured loans to non-investment-grade vehicles. People invest in BDCs, which are publicly traded equities, mainly as income plays because they generally pay hefty dividends.
Closed-end funds differ from open-end mutual funds in that they offer a fixed number of shares that trade daily on securities exchanges. The share price of a closed-end fund can trade above or below its net asset value, enabling investors to buy them at a discount or sell them at a premium to a fund’s NAV. These products can appeal to income investors because they often invest in less-liquid investments with higher yield potential.
“VPC has some elements of equity income and some elements of fixed income, so hybrid is the right way to describe it,” says Bill Smalley, executive managing director and head of product strategy and management at Virtus ETF Solutions.
The VPC fund launched in February, and already has $208 million in assets under management.
“We’re getting a lot of phone calls from investors asking how this thing works,” Smalley says. “I think the headline yield sticks out for them.”
Indeed, a 13% distribution yield is eye popping. But so is the fund’s 30-day SEC yield of 8.82%.
The distribution yield is a backward-looking number that can be calculated in different ways. The SEC yield follows a standardized formula that makes it the preferred method to compare funds. It’s based on the past 30 days of accrued income and it accounts for interest and dividends, as well as a fund’s expenses. It generally indicates what the fund is expected to pay.
Risk/Reward
As indicated earlier, private credit vehicles have higher yields because they’re riskier than traditional government or high-grade corporate bonds.
BDCs, for example, are mainly a macro play on the economy. Shares prices of many BDCs plunged during the financial crisis when some of the businesses in BDC investment portfolios couldn't service their debts, which negatively impacted the financials at many BDCs.
“[BDCs] skew toward small companies, so you’re taking on the credit worthiness of something that’s smaller and less proven,” Smalley says. “And there’s partially a liquidity premium built in to these yields, so if there’s a credit crunch private credit could be hit a little harder than corporates."
“Nonetheless, one of the interesting attributes of these BDCs is that many of them are run by the best private-equity management talent in the world,” he continues. "They have different objectives. So while some BDCs didn’t do well during the financial crisis, a lot of those were distressed debt BDC strategies. BDCs run the gamut—some can be a steady alternative income play or can be an opportunistic distressed [debt] play. Our approach with BDCs is to provide diversified exposure to all of that.”
According to fund literature, the VPC fund’s total expense ratio is 7.64%. That figure includes both the management fee and the acquired fund fees incurred by the underlying funds within VPC’s portfolio, which Virtus is required to report. Investors pay just the management fee of 0.75%.
Competitors
It appears that VPC is unique in terms of having “private credit” in its name, and for its mixed portfolio of BDCs and closed-end funds. Its most direct competitor is probably the VanEck Vectors BDC Income ETF (BIZD) that’s linked to an index that tracks the performance of BDCs.
The VanEck fund offers a 30-day yield of 8.83%, Its net expense ratio inclusive of acquired fund fees is 9.62%, but investors pay only the capped management fee of 0.40%. BIZD has gained more than 26% year-to-date and has a five-year average annual return of 5.5%.