Private credit enjoyed tremendous growth over the past decade. The draw was clear: when policy rates were near-zero, investors sought alternatives to low-yielding products and strategies. Private credit delivered—offering a differentiated source of income, the potential to outperform public markets, and healthy yields with lower volatility.1
Recently, though, the narrative has shifted. Some market participants worry that private credit poses systemic risk to financial markets. We do not share that perspective. In our view, recent headlines have conflated isolated pockets of weakness with a broader deterioration in private credit fundamentals.
But this is not a market for complacency. Performance dispersion is widening among private credit fund managers. AI-driven disruption is hitting software-heavy portfolios. Yields are normalizing.
It’s a good time to reassess the outlook for private credit — identifying possible pitfalls to avoid and opportunities to seize. Manager selection is more critical than ever. Our full analysis of the private credit market is available here.
In this report we focus on an opportunity we find compelling: a kind of private credit known as asset-backed finance (ABF).
What is asset-backed finance? These are loans secured by underlying assets such as equipment leases, auto loans and residential mortgages. A long-established form of credit, ABF is attracting a fresh look, and with good reason. We think now is an opportune time to consider building exposure to asset-backed finance as part of a diversified private credit portfolio.
To be clear: Asset-backed finance is a complement, not a substitute, for direct corporate lending. Depending on capital structure and risk profile, strategies in this area have the potential to generate returns in the high single digits (roughly a 200-250 basis points premium to comparable public securitized products), with some segments targeting higher levels.2 ABF may also provide a way to diversify credit risk from pure corporate exposure, which can be especially useful as corporate direct lending returns normalize. The structural tailwinds supporting ABF—bank retrenchment and regulatory pressure on traditional lenders—seem likely to persist. Finally, ABF, as a durable allocation within private credit, can potentially enhance portfolio resilience across credit cycles.
Asset-backed finance is essentially private lending secured by diversified pools of contractual cash flows and tangible collateral. The underlying assets typically generate predictable payment streams that service the debt independent of any single corporate borrower’s financial performance.
That’s a bit of a mouthful, but here’s the important point: ABF offers multiple levels of diversification. The underlying collateral pools consist of many individual cash flow streams backed by a multitude of distinct assets. Look at the wide range of ABF collateral below.
You take on very different risk exposures when you invest in asset-backed finance versus corporate direct lending.
In direct lending, credit risk analysis centers on a single borrower’s enterprise value and cash flow. Collateral consists of corporate assets whose value depends on ongoing business operations. The entire principal is repaid in a single lump sum when the loan matures. Debt covenants can mitigate risk. But given the growth in the industry, some covenants have become increasingly permissive—so-called “covenant-lite.”3
Asset-backed finance is a different story altogether. Credit risk is spread across numerous underlying debtors. Collateral consists of tangible assets or contractual receivables with observable market values independent of any operating company.
Critically, ABF principal is returned through the life of the investment. A typical ABF investment structured as a finance lease aims to return roughly three-quarters of principal within the first three years. Thus ABF investments naturally deleverage over time, while corporate loans accumulate refinancing risk as maturity approaches. Those are very different risk trajectories.
Within asset-backed finance, investors can choose among a variety of risk/return profiles. The spectrum ranges from investment-grade senior tranches which may offer rates that can fall into the mid-single digits to mezzanine positions that typically offer higher distribution rates to equity holdings targeting the highest net returns.
How does today’s ABF market compare to its counterpart in the years leading up to the 2008 global financial crisis (GFC)? We hear this question a lot.
Any discussion of asset-backed securities (ABS) must acknowledge the role played by subprime mortgages and other structured financial products during the GFC. But today’s market backdrop is very different.
The pre-GFC asset-backed securities market featured opaque off-balance sheet structures and misaligned incentives between loan originators (borrowers) and loan investors. Ratings greatly obscured underlying credit quality. Those failures were real and consequential.
Post-GFC regulation strengthened the ABS market. Risk retention requirements now mandate that loan originators maintain meaningful first-loss exposure. This means their incentives more closely align with those of investors in their loans. In addition, enhanced disclosure requirements improved transparency, and capital rules forced more disciplined underwriting.
The case for ABF begins with the power of diversification. How might ABF fit into a well-diversified credit portfolio?
As direct lending allocations have grown, investors may have more corporate credit exposure than they realize. As we’ve discussed, ABF offers exposure to consumer payment behavior, real asset values and contractual cash flows, all of which often move independently of corporate earnings.
Consider, for instance, a pool of auto loans. Their performance depends on whether individual borrowers make their scheduled payments—a dynamic driven by employment and household balance sheets, not corporate strategy or competitive positioning.
The second pillar of the case for ABF relates to structural tailwinds—specifically, post-GFC banking regulation.
Post-crisis regulations imposed higher capital requirements, liquidity coverage ratios and risk-weighted asset charges on banks. The new rules made asset-backed finance far less attractive for many banks.
Non-bank lenders offering ABF stepped forward to fill the financing gap. Industry estimates suggest the global investable ABF market is ~USD 7 trillion today, with private capital representing only ~5% (compared with private capital’s ~9% share of corporate lending).4 We expect private capital to increase its market share in ABF in the coming years.
Until recently, some private credit managers didn't pursue investing in ABF; corporate direct lending was generating robust risk-adjusted returns5, and with far less complexity vs. ABF.
Now, three forces are converging. First, capital has flooded into direct lending, compressing spreads and pushing managers to hunt for new return sources. Second, banks continue to retreat from asset-intensive lending. Third, insurers need long-duration, high-quality yielding assets to match their liabilities—a mandate ABF's collateral profiles fit far better than floating-rate corporate loans.6
The dynamic creates pricing power for private lenders. Borrowers (loan originators) value certainty of funding and comprehensive capital solutions that banks may no longer wish to provide. Private ABF lenders can command higher spreads (and potentially deliver greater returns to ABF investors) relative to comparable public ABS.
The third pillar in the case for ABF: relatively new evergreen and open-ended vehicles, which better match the cash flow profile of ABF investments. These evergreen vehicles allow ABF funds to continuously deploy and reinvest capital, which traditional drawdown structures cannot do.
Asset-backed finance is complicated—there’s no getting around it. In a corporate loan, credit analysis focuses on a single borrower. But ABF requires granular and ongoing assessment of loan collateral and the capabilities of loan servicers, among other considerations. Covenant compliance must be verified, and performance triggers tracked on a regular basis.
The inherent complexity of ABF is precisely why ABF can offer the potential for higher rates and excess returns relative to less complicated securities. In short, ABF is not a passive allocation. It demands specialized expertise.
Here’s another wrinkle to the ABF market: These investments usually depend on third parties to originate and service underlying loans. These are the “counterparties” to an ABF transaction. An investor in ABF must therefore weigh counterparty risk. If an originator fails or a servicer underperforms, investors may suffer losses even if the underlying collateral remains sound.
ABF investors have some structural protections from servicer and originator problems. Bankruptcy-remote special purpose vehicle (SPV) structures legally isolate assets from originator insolvency. Backup servicing arrangements ensure continuity if primary servicers fail. Performance triggers force deleveraging before problems become acute, and lenders can take control of collateral through foreclosure if necessary.
These protections do not eliminate servicer risk entirely. But they help contain it within manageable bounds and provide paths to remediation when issues arise.
A sound private credit portfolio is a well-diversified private credit portfolio. That time-tested principle is especially resonant today given a normalization in corporate direct lending yields, which accounts for an outsized share of many private credit portfolios.
Compared with direct lending, ABF offers a range of risk and return drivers. As we’ve discussed, its diversification benefits draw mainly on its exposure to consumer and real asset credit rather than corporate credit.
We believe ABF can play a strategic role in a private credit portfolio. Now is a potentially opportune time to invest.
Talk to your J.P. Morgan team about what private credit allocation might be appropriate for your wealth plan.
KEY RISKS
Investing in alternative assets involves higher risks than traditional investments and is suitable only for sophisticated investors. Alternative investments involve greater risks than traditional investments and should not be deemed a complete investment program. They are not tax efficient and an investor should consult with his/her tax advisor prior to investing. Alternative investments have higher fees than traditional investments and they may also be highly leveraged and engage in speculative investment techniques, which can magnify the potential for investment loss or gain. The value of the investment may fall as well as rise and investors may get back less than they invested.
Private credit securities may be illiquid, present significant risks, and may be sold or redeemed at more or less than the original amount invested. There may be a heightened risk that private credit issuers and counterparties will not make payments on securities, repurchase agreements or other investments. Such defaults could result in losses to the strategy. In addition, the credit quality of securities held by the strategy may be lowered if an issuer’s financial condition changes. Lower credit quality may lead to greater volatility in the price of a security and in shares of the strategy. Lower credit quality also may affect liquidity and make it difficult for the strategy to sell the security. Private credit securities may be rated in the lowest investment grade category or not rated. Such securities are considered to have speculative characteristics similar to high yield securities, and issuers of such securities are more vulnerable to changes in economic conditions than issuers of higher-grade securities.
Real estate, hedge funds, and other private investments may not be suitable for all individual investors, may present significant risks, and may be sold or redeemed at more or less than the original amount invested. Private investments are offered only by offering memoranda, which more fully describe the possible risks. There are no assurances that the stated investment objectives of any investment product will be met.
This material is for informational purposes only, and may inform you of certain products and services offered by private banking businesses, part of JPMorgan Chase & Co. (“JPM”). Products and services described, as well as associated fees, charges and interest rates, are subject to change in accordance with the applicable account agreements and may differ among geographic locations. Not all products and services are offered at all locations. Please read all Important Information.
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