Why Private Credit Outshines Public Credit in a Rate-Cutting Environment

While private credit has existed for decades, capital flowing into the sector has substantially accelerated in recent years. As a result, the lines between private and public credit markets are becoming increasingly blurred, and there has been a proliferation of new products addressing different investors’ requirements regarding liquidity and returns. These changes make it hard for financial advisors, enticed by the favorable environment for private credit, to know which strategies and fund structures are best suited to their clients’ goals.

While private credit, the issuing of loans by non-bank lenders to corporate borrowers, has existed for three decades, the asset class has tripled in assets under management since 2012.¹ The private credit market has benefited from economic changes, including last year’s regional bank collapses, where private lenders stepped in for banks, and the recent rate cuts, which have provided a more favorable lending environment for borrowers and lenders. According to the International Monetary Fund, in 2023, the private credit market topped $2.1 trillion globally in assets and committed capital, and around three-quarters of this was in the U.S.²

Private credit has been a lucrative strategy for some investors. It can offer current income from contractual cash flows, an illiquidity premium, historically lower loss rates relative to public credit, diversification and customized portfolio construction, according to Morgan Stanley. The firm’s data shows that, since the global financial crisis, direct lending (the most popular private credit strategy) has provided higher returns and lower volatility compared to both leveraged loans and high-yield bonds. When measured over seven different periods of high interest rates between the first quarter of 2008 and the third quarter of 2023, direct lending yielded average returns of 11.6%, compared with 5% for leveraged loans and 6.8% for high-yield bonds.³ McKinsey & Company notes that while the bulk of the market’s growth over the past decade has been concentrated on direct lending strategies, there are more opportunities in private credit. They estimate that the addressable market could be more than $30 trillion in the U.S. alone and argue that four asset classes will increasingly shift to nonbank lenders: asset-backed finance, infrastructure and project finance assets with relatively long durations, jumbo residential mortgages and higher-risk commercial real estate.⁴

According to Crystal’s proprietary data, this year advisors recognized the appeal of the asset class, and significantly reallocated from traditional fixed income into private credit. Advisors were enticed by significant yield and divided potential. However, there are challenges to investing in private credit strategies, and this can be an intimidating landscape as it continues to evolve.

Private credit is relatively illiquid compared to public credit. While investors with a longer-term horizon can manage this risk, it can be more challenging for investors who need liquidity access. However, private credit funds do provide some liquidity by generating yield. If this continues at an attractive rate, it deserves a place within a high-net-worth client’s portfolio.

Other concerns include the potential for higher default rates compared to public credit, opacity and areas of systematic risk. The first concern can be addressed by noting that, due to the current economic backdrop, defaults are less likely. While some are wary of investing in private markets due to opacity concerns, there are several ways investors can collect data on private credit: banks and credit unions, Business Development Companies (BDCs) that are regulated and leverage loan funds all report information on a quarterly basis.⁵ On top of this, two areas of systematic risk affect private credit: correlation with the broader economy, and any risk related to looser underwiring process paired with poor risk management applications.⁶ It is essential that financial advisors conduct thorough due diligence into the risk management practices of the managers they are investing with.

There is also a lack of familiarity with the space. Private credit strategies often get bucketed or compared to high-yield strategies, and the landscape continues to shift. As the private credit sector expands, it is taking on characteristics usually associated with public markets. Barings has merged its public and private asset-backed teams, noting that private markets are taking over areas once dominated by public markets, and they expect the two to interact more over time.⁷ Financial advisors seeking to take advantage of the current economic backdrop need to be aware of these structural shifts.

We are beginning to see a proliferation of private credit products. Many traditional asset management shops have purchased private credit shops of late. For example, this year Janus Henderson, Blue Owl Capital and Brookfield all indicated interest in, or purchased, stakes in asset-backed credit specialists, according to FundFire.⁷ McKinsey & Company argues that banks could partner with asset managers and institutional investors to sell assets, issuers could move upstream into origination, and asset managers could distribute products to new end investors, such as insurance companies and high-net-worth individuals.⁸ It is important for advisors to conduct thorough due diligence to choose the funds that are right for them, via the most appropriate platforms.

As we wait to see how sustained rate cuts might further amplify private credit’s attractiveness, advisors should take the time to explore private credit opportunities as part of a diversified portfolio strategy. Private credit can offer a stable and lucrative alternative to public markets, so long as advisors are aware of the potential challenges.

Footnotes:

1. State Street. Jul. 2024. The rise of private credit: A new frontier for investors.
2. International Monetary Fund. Apr. 8, 2024. Fast-Growing $2 Trillion Private Credit Market Warrants Closer Watch.
3. Morgan Stanley. Jun. 20, 2024. Understanding private credit.
4. McKinsey & Company. Sep. 24, 2024. The next era of private credit.
5. Bunja, Rudolph. Alter Domus. May. 8, 2024. Private credit markets offer meaningful benefits that can outweigh related risks.
6. Bunja, Rudolph. Alter Domus. May. 8, 2024. Private credit markets offer meaningful benefits that can outweigh related risks.
7. Shahidullah, Sabiq. Nov. 21, 2024. FundFire. Strong Private Credit Outlook Fuels M&A Interest.
8. McKinsey & Company. Sep. 24, 2024. The next era of private credit.