According to data from the Federal Highway Police, in 2021, there were 64,441 car accidents in Brazil and more than 5 thousand people died, only on federal highways. That is, we are not counting accident data on other roads, whether urban or not. Undoubtedly, there are great risks in using a car, just as there is also risk in investing in private credit. However, how do we assess whether it pays to take these risks?
It is not my intention to calculate whether it is worth the risk of using a car, but, intuitively, we know that it is worth it due to the gain in time on the move, but care must be taken in the way it is used.
A similar reasoning can be employed in private credit. Investing in this category makes up for the gain in time on the journey to independence, but care must be taken when investing.
We know that it is not possible to eliminate the risk of using a car. No matter how careful we are, someone without the same care can always come along and cause the accident. The most we can do is reduce the risk.
The same occurs with our risky investments, including private credit.
The precautions necessary to reduce the risk of using cars are known. But what about investing in private credit?
In early 2023, even those who took every precaution in private credit were caught by surprise with Americanas’ accounting fraud. Analogously, this case is similar to that of the driver of another car that collides with ours.
Sometimes there’s no way to avoid the beat.
However, if you are taking proper care, it is possible to reduce the consequences. The same would happen with the Americans.
So, let’s do a simple calculation of how much time it is possible to reduce the journey to financial independence by investing in private credit and how to mitigate the risk of “beats”.
At this time, I will focus on exempt private credit and without the Credit Guarantee Fund (FGC). I will illustrate the calculation of private credit bonds with FGC in the next chapter.
Currently, federal public bonds, with maturity of close to 10 years and referenced to inflation, remunerate IPCA+6% per annum.
Private bonds such as debentures, CRIs and CRAs, exempt from income tax and maturing in 10 years, yield IPCA+7% per annum or higher.
Assuming that the IPCA throughout the period is 5% per annum, the return on the above exempt security would be equivalent to the yield of IPCA+9% per annum if it were taxed.
This real yield is 50% higher than the real return on the government bond, which is also taxed.
With this return, considering the same example used in Chapter 7, the time for your retirement could be reduced by almost a third, that is, from 30 years to 22 years. Returning to the initial analogy, even with risk, we use the car, because we gain time on the journey.
But how can you reduce the risk of the worst happening?
Let’s go back to the automobile example. To reduce the risk of accidents, you need to drive slowly and safely.
In the case of corporate bonds, “driving slowly” is having a reduced allocation per issuer. For example, always limiting between 1% and 2% the participation of each issuer in its portfolio.
So split the exposure across multiple issuers. The more the better. But it’s not investing in just anyone.
When it comes to security, an alternative would also be to restrict your investment to only bonds rated AA, AA+, or AAA by rating agencies.
Studies by S&P Global Ratings show that less than 1% of companies rated AA or higher have credit problems over a 10-year horizon.
Consider the example above of a portfolio of corporate bonds rated AA or higher and with 20 issuers or companies such that each only has a maximum exposure of 2% of equity.
Even with all these precautions, an accident may occur, as happened with the Americanas fraud.
However, even if 3 companies out of 20 go bankrupt and you lose all the capital invested in these 3, you will still continue to have a higher return than government bonds in 10 years.
I am not arguing that you should concentrate your fixed income portfolio on private bonds exempt from fixed income, but showing that if you also add them to your portfolio, in a safe way, you can reach financial independence faster.
Remember, as with everything, the biggest risk is in the dosage and how to use it.
Michael Viriato is an investment advisor and founding partner of Investor House.
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Book: The Journey to Financial Independence
Understand how you will achieve your financial independence
Living on an income is the last step on the journey to financial independence
These are the biggest questions about the journey to independence
Part 1 Construction of the plan
Chapter 1 The first step in building the blueprint for financial independence
Chapter 2 How do you define the rate of return in your plan for independence?
Chapter 3 Find out what equity you need to achieve your financial independence
Chapter 4 On your journey to independence, don’t overlook the importance of this factor
Chapter 5 Understand the two ways I applied to increase my saving capacity
Chapter 6 If You Double This Factor, Your Equity Can Multiply Much More
Chapter 7 Connecting the dots to build your plan
Part 2 Assembling the portfolio to lead you to financial independence
Chapter 8 Before making any investment, define these two factors
Chapter 9 You should not build an income portfolio if you want to reach equity to live on income
Chapter 10 Avoid these two common fixed income investor mistakes
Chapter 11 In fixed income, see when private credit is better than government bonds
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