Stress testing is no longer just something banks and regulators do. It has become an essential discipline for investors seeking consistent long-term returns, particularly when things get a little choppy.
Whether interest rates stay higher for longer, property markets become more volatile or economic growth slows, investors should understand how their portfolio is likely to perform under different scenarios. That includes reviewing the role private credit plays in delivering income, diversification and stability.
Private credit has attracted growing interest from investors seeking regular income and an alternative to the volatility of listed markets. However, an investment should not be assessed solely on its performance under favourable conditions.
Investors also need to ask what could happen if borrowers face financial pressure, asset values decline, projects take longer to complete, or distributions are delayed.
Stress testing is primarily about identifying vulnerabilities before market conditions expose them. It can help investors determine whether their private credit allocation remains consistent with their objectives, risk tolerance and liquidity needs.
For self-directed investors, several practical tasks can help you better understand your portfolio and where your strengths and weaknesses lie.
1. Review the concentration of your investments
The first step is to understand where your private credit exposure sits and to make sure you don’t have all your eggs in one basket.
An investor may hold several different investments but still be heavily concentrated in one sector, borrower type, geographic region or stage of the economic cycle. For example, multiple loans secured against similar property developments may behave in comparable ways if construction costs rise or property settlements slow.
Investors should understand their exposure across borrowers, industries, locations, loan maturities and underlying assets. They should also consider how much of their total wealth is linked to the same market.
Diversification does not remove risk, but it can reduce the effect of a problem affecting one borrower, asset or sector.
2. Test the impact of delayed income
Regular distributions are one of the major attractions of private credit. Investors may use this income to meet living expenses, fund retirement or support other financial commitments. A stress test should therefore consider what would happen if distributions were reduced, deferred or suspended for a period. This is more about testing YOUR resilience if things change, rather than the resilience of your investments.
Also read: What’s Been Driving Positive Correlations?
Could you continue to meet your expenses if income stopped for three, six or 12 months? Would you be forced to sell another investment at an unfavourable time?
Maintaining an appropriate cash reserve can help investors avoid becoming overly dependent on distributions arriving exactly as expected.
3. Examine the transparency of the underlying security
Investors should understand exactly where their money is invested and how much visibility and control the manager has over each underlying project or investment. Lack of insight into the performance of the underlying asset (and the inability to correct course in a timely fashion) is one of the key reasons behind poor performance of private credit funds.
A manager investing in projects it directly controls can often maintain a closer understanding of project costs, construction progress, sales performance, valuations and emerging risks. This direct involvement may allow the manager to identify potential issues earlier and respond before they materially affect the investment.
Self-directed investors should ask whether the manager originates and manages its own projects, how frequently performance is reviewed and what access it has to current financial and operational information. They should also examine the quality of investor reporting and whether the manager clearly explains any delays, cost increases or changes in risk.
Transparency does not eliminate investment risk, but better information and closer oversight can support earlier intervention and more informed decision-making.
4. Understand the borrower’s capacity to repay
Investors should examine how each borrower intends to repay the loan. Repayment may depend on asset sales, project completion, refinancing or operating cash flow. Each of these strategies carries different risks.
One of the major risks associated with property developments is receiving development approvals and then being able to sell and settle properties. A useful stress test could assume that sales take longer than expected, refinancing becomes more expensive or sales do not happen as quickly as forecast. Investors can then assess whether the borrower has sufficient equity, cash reserves or other options to manage the disruption.
The borrower’s experience and financial capacity are also important. A strong track record does not guarantee future performance, but it can indicate how effectively the borrower may respond when conditions become more difficult.
5. Consider the effect of higher interest rates
Higher rates may increase investor returns on variable-rate loans, but they can also place additional pressure on borrowers.
Investors should consider whether a borrower can continue servicing the loan if interest rates remain elevated or increase further. They should also assess whether higher finance costs could reduce project profitability, weaken interest coverage or make refinancing more difficult.
A higher headline return is only attractive if the underlying borrower can sustainably meet the associated repayments.
6. Review liquidity and maturity dates
Private credit is generally less liquid than listed shares or exchange-traded funds. Investors may not be able to withdraw their capital before a loan matures, and repayments can sometimes be extended.
Investors should list the expected maturity dates across their portfolio and identify any periods when a large proportion of their capital is due to be returned.
They should then compare those dates with their anticipated financial needs. If several investments mature at the same time, or if an investor expects to need capital within that period, greater liquidity elsewhere in the portfolio may be appropriate.
7. Examine the manager’s risk controls and reputation
Understanding the quality, experience and track record of the investment manager is a critical part of any initial review of your investment and ongoing testing. Like all businesses, fund managers can change over time, and their performance can improve or deteriorate.
When assessing your manager, important questions include how frequently loans and valuations are reviewed, what their track record of delivering on targeted returns is, what reporting investors receive, how arrears are handled and whether the manager has experienced personnel capable of managing workouts or enforcing security.
8. Reassess the role of private credit in the wider portfolio
Private credit should be considered as one part of a broader investment strategy.
Investors need to assess how it interacts with their exposure to equities, property, cash, fixed income and superannuation. Someone who already owns several investment properties, for example, may have greater exposure to the property cycle than their private credit allocation initially suggests.
The appropriate allocation will vary according to an investor’s objectives, time horizon, income requirements and capacity to absorb losses or delays.
Make stress testing a regular discipline
Stress testing should not be a one-off exercise completed only when markets become unsettled. Investors should review their assumptions regularly and whenever their personal circumstances, investment objectives or economic conditions change.
Private credit can play a valuable role in generating income and diversifying a portfolio. However, its benefits are best understood when investors look beyond the advertised return and carefully examine the risks supporting it.
The purpose of stress testing is not to eliminate uncertainty. It is to make sure investors are prepared for it.
