Is private credit the right tool for these uncertain times?

The return drivers of the past decade are not likely to provide outsized returns for the next decade. With traditional public markets not delivering return and yield as well as before, we have seen rising interest among investors in alternative strategies—especially private credit.

A range of fixed-income instruments with differing return profiles sit under the “private credit” umbrella. Some are more “bond-like” strategies to generate income. Others are more “equity-like,” seeking higher returns. We think its variety can make private credit a potential opportunity for investors with varying risk tolerances and portfolio goals.

What is private credit? Any privately negotiated loan made outside the public debt markets.

The majority of today’s private credit market is senior direct lending. “Senior” because holders are first in line for repayment in a default. Direct lending usually finances middle-market businesses (typically, private equity sponsors use direct loans to finance acquisitions). Other types of private credit include real estate loans, “special situations” and other niche, specialized credit strategies.

Private credit markets have grown quickly

While private credit is not the most well-known asset class, it has expanded in the last decade, driven by increased demand from investors and borrowers, and now approaches the size of some public fixed income markets. 

What explains private credit’s often higher yields? Private market borrowers pay higher rates because they need liquidity and cannot get bank loans—largely due to regulations that took effect after the 2008 global financial crisis.

Large institutions were early to the private credit market, seeking higher yields when they were not available in traditional (public) fixed income markets. Now that the market is larger, more established and easier to access, we observe rising demand from private borrowers, too. Previously, private credit funds tied up liquidity but today, more flexible (“open-end”) instruments offer investors more liquidity.  

Seeking higher yield or income? Direct lending may be a good alternative

Income—essential for many investors—has traditionally been achieved by allocating to bonds and loans. But bond yields (while rising) remain low, historically. Direct lending may increase income. It is also relatively lower in risk than other types of private credit, with relatively lower returns. Direct lending has historically been marked by stable, forecastable income flows.

Because this is “senior” direct lending, lenders have priority for repayment and the loans are often secured. Direct loans typically pay floating-rate coupons, although with “floors” in low rate environments. These features have helped direct lending generate more favorable returns, with greater consistency, than other kinds of debt. 

Funds that hold these assets usually add leverage (they invest with borrowed funds), increasing return potential as well as risk. Because there is less transparency than in public bond markets, managers must have strong credit research and underwriting capabilities to select high quality companies. In this market, manager selection is critical.

Potentially enhanced returns outside of equities

Private credit is not just a bond or loan replacement meant for yield. If you’re seeking to potentially enhance returns, have a higher risk tolerance, and perhaps want a substitute for equities—or to diversify your equities exposure—consider special situations and distressed credit.

Like “buying low” in equities, here deeply discounted, “stressed” debt may be bought from a current owner, or a loan could be made at a high rate to a distressed company. Sometimes the lender expects to take ownership (“loan to own”) when the company’s value has risen. Distressed credit might take the form of a “bridge loan” while a company gets on its feet, or another customized solution.

Unlike senior direct lending (lowest risk-return), special situations and distressed credit strategies seek higher absolute returns via increased risk—in the security and/or the company. Distressed credits may be “junior” (lower in priority for payback).

Generally, special situations and distressed borrowers are going through a transitional phase and need capital. Perhaps the company experienced challenges related to COVID-19, or management made mistakes. Perhaps they took on more debt than they could handle.

Often these strategies will not include a current income or yield component (although some do). Investors take this into account and seek to build in compensation, structuring the credit to have a higher total return.

Mitigating the risks                              

Private credit is less transparent than bonds—it is not rated by credit rating agencies. Because interest rates are adjustable (“floating”) with market rate conditions, borrowers may be strained when market rates rise—as is the case with many other debt instruments, as well. For investors, holding floating-rate credit when rates are rising should be beneficial.

To mitigate the risks in private credit, fund managers are often highly specialized. They build relationships with the companies they finance, negotiate protections and understand their borrower companies well, sometimes sitting on the board of directors. The two sides can work out problems during times of stress.

We think all these characteristics can make private credit compelling and worth consideration if it fits your needs and investment objectives. Private markets are by nature more complex and less transparent than public markets; navigating private credit requires seasoned investors with special expertise. Risks may include inflation, rising rates and other economic unknowns.

We can help

For a thoughtful analysis of how private credit might fit into your portfolio and best align with your family’s goals, reach out to your J.P. Morgan team.