With Yields Topping 13%, Private Credit Is Becoming The Next Big Thing

Get ready to hear a lot more about private credit. This under-the-radar market has been quietly booming in popularity among some of the world’s big alternative asset managers – Blackstone and Apollo, to name just two. And now it’s also drawing the attention of blue-chip companies, who are seeing it as a cheaper and faster place to raise money. Here’s what you need to know.

What is private credit?

Simply put, the private credit market allows institutions that aren’t traditional banks to lend directly to companies. That can mean a potentially lower interest rate on a loan, and a simpler, less regulated, more confidential process, especially compared to issuing corporate bonds in the public market.

A lot of banks are being forced to reduce commercial lending because of capital constraints – the requirement that they hold a certain amount of assets on hand, relative to what’s been loaned out. And that’s where private credit is stepping in, filling the void and providing certainty and lending speed. The total private credit market was around $1.4 trillion at the beginning of this year and is expected to grow to $2.7 trillion by 2027.

Private debt assets under management by region, measured in billions of dollars, since 2010 and forecast to 2027. Source: Preqin.

These loans usually have floating rates rather than fixed ones, so the amount of interest the companies pay will fluctuate with the market – and that gives lenders some protection against the possibility of rising interest rates.

What kind of interest rates are we talking about?

There are different types of private credit, with different risk profiles. And the higher the risk, the higher the interest rates will be. Here are some of the main types of private credit out there:

Senior, secured loans provide relatively stable yields and are lower on the risk and return spectrum. These loans are secured against collateral (think: assets), so there’s some built-in protection for lenders, reducing the need for the highest lending rate.

Unsecured lending – also known as “junior capital” – provides borrowers with unsecured loans. These are riskier than secured loans but offer the lender a higher yield for taking on that increased risk. They often offer upside to the lenders through an equity “kicker”: in other words, the lender gets upside exposure if the company performs well.

Distressed debt is what you get when companies are struggling with meaningful challenges. The risk is highest in these cases but the interest rate is priced accordingly, so the returns can be high.

Finally, there’s lending for special situations, and usually, these loans are sought because of big corporate happenings, like to pay for an acquisition. The risks (and the yields) on these vary, depending on the quality of the borrower.

What are the advantages of having private credit in your portfolio?

There are at least three solid benefits to bringing some private credit into your portfolio.

The first is income generation. Private credit offers a higher yield than most asset classes – 3 to 6 percentage points higher than publicly traded high-yield credit funds – for example, the iShares iBoxx High Yield Corporate Bond ETF (ticker: HYG US; expense ratio: 0.49%), which is currently yielding nearly 9%. And that’s because borrowers are willing to pay a premium to be assured that they’ll get the loan, quickly and flexibly.

The second is historically lower loss rates. This market’s loss ratios are lower than those of other high-yield fixed-income instruments. That could be because private lenders can carry out better due diligence on the companies.

And the third is diversification. Private credit doesn’t move in lockstep with other assets like stocks or bonds. What’s more, since the 2008-09 financial crisis, private credit has provided higher returns and lower volatility compared to both leveraged loans and high-yield bonds.

Private credit market performance, over time. Source: Cambridge Associates.

So what's the opportunity here?

Loads of high-yield loans are coming up for repayment soon. And that means a lot of companies are expected to be eying the private credit market for solutions. Interest rates are sharply higher than they were just a year ago, so companies may look for “junior capital” type solutions to reduce their expenses and increase their cash flow. And if the economy enters a recession, as many expect, a flurry of distressed lending opportunities is likely to appear. However, you might want to be wary if that’s the case because a severe recession could result in a spike in bad loans.

Some of the world’s biggest financial institutions have publicly traded funds that allow you to take advantage of these quite stellar lending yields. Here are some of their year-to-date returns and estimated yields:

Total return (price and dividend yields) of private credit vehicles so far this year, along with the 20+ year US Treasury Bond ETF. Source: Bloomberg.

You could consider investing in the Goldman Sachs Business Development Company (GSBD) with its 12.4% dividend yield, or the FS KKR Capital Corp (FSK) with its 14.2% yield. There’s also the TriplePoint Venture Growth BDC (TPVG) with a 15.3% yield, the Nuveen Credit Strategies Income Fund (JQC) with a 12.8% yield, and the Blackrock Capital Investment Corp (BKCC) with a 10.8% yield.

These private credit funds have done well this year as the steady increase in interest rates has driven up the returns. Remember, most of these loans have floating rates, so their yields have risen in tandem with interest rates. Plus, the US economy has been mostly fine and dandy, so there haven’t been a lot of loan losses. Contrast that with the iShares 20+ Year Treasury Bond ETF (TLT; 0.15%), which has really struggled this year as interest rates moved higher.

If interest rates stay higher for longer, and the US avoids a recession, double-digit returns could easily continue for these private credit investment vehicles. On the other hand, if a recession hits, credit losses will increase, and these estimated dividend yields will fall. And in that case, the iShares 20+ Year Treasury Bond ETF would be expected to rally. Still, even in a recession, the private credit market can find opportunities in distressed situations. That’s why so many of those “smart money” big money institutions are looking to take advantage of this growing opportunity.