Is Risk in the Private Credit Market Increasing?
Weekly Investment Update | By Brian Schreiner
The allure of private credit, with its (relatively short) history of higher yields and lower volatility compared to traditional fixed income, has drawn significant interest in recent years.
Evolving market conditions and inherent structural characteristics are signaling a potential uptick in risk. We have favored private credit in recent years, but there are several reasons we are now moving away from the asset class.
Slowing economic growth has increased the risk of default and lower asset prices. Volatility in asset prices has increased significantly, due to slower economic growth, rising geopolitical risk, tariff wars and tighter financial conditions. The chart below was taken from the International Monetary Fund Global Financial Stability Report (April 2025).
Macrofinancial downside risks have increased meaningfully. Despite the April market correction and subsequent rebound, stock market valuations remain high and bond yields have remained relatively stable even as several macroeconomic indicators, such as U.S. GDP, which was negative in the first quarter, increasing the risk of stock and bond market corrections this year. If the U.S. economy goes into recession, loan defaults, especially among higher-risk creditors, are likely to increase.
Private credit has limited liquidity and tail risks are increasing. Private credit’s limited liquidity arises from its non-public trading, direct and customized deal structures. Investors’ capital is locked-up in loans to companies and the less developed secondary market means that it’s not easy for fund managers to get liquidity if investors demand it. If private credit funds face an increase in redemption requests from investors, it’s best to be at the front of the line. Investors at the back of the line or even in the middle may end up getting stuck holding the bag if loan defaults increase. We still believe that the most likely outcome for private credit is that it will survive and possibly even thrive, but we believe the tail risks are increasing, so we are choosing to step aside.
Concerns around default risk are increasing. Private credit funds often have exposure to leveraged loans, a type of debt financing provided to companies that already have significant debt or a low credit rating. Default rates in leveraged loans are historically higher than investment grade corporate debt and government debt, two asset classes we prefer at this time. Almost half of borrowers from direct lenders had negative free operating cashflow. A Morningstar report on first-quarter credit estimates showed a slowdown in deal activity as well as lower estimated credit quality for new and existing borrowers. “Around 80% of the restructuring situations that we currently see involve private credit,” says Jat Bains, who leads the restructuring and insolvency group at law firm Macfarlanes. George Mills, a partner in a turnaround and restructuring team, added that “nearly all” of the complex restructuring situations his firm sees now include private credit funds.
The return premium may be shrinking. The return premium is the additional return (yield) investors can expect above a comparative rate. It’s still too early to be sure, but from anecdotal evidence we’ve seen, returns from private credit funds are running below 2023 and 2024 levels and returns from publicly traded investment grade floating rate debt and short-term government bonds have increased or remained stable. The added return investors have been receiving from private credit may be decreasing, making its more liquid counterparts more attractive in our view.
The tide has never gone out on private credit. Warren Buffett’s most famous quote might be, "Only when the tide goes out do you discover who's been swimming naked." The private credit market is relatively new. It developed primarily in response to banks’ reduced lending activity after the Global Financial Crisis. Since then, the economy has witnessed an unusually long string of years without a recession so we’ve never had the opportunity to see how this market responds to a crisis or major economic slowdown. Have private credit fund managers relaxed their credit standards during the smooth-sailing we’ve seen since 2011? What will the default rate be in private credit during a recession? We simply don’t know because we’ve never seen how this asset class behaves during challenging times.
Foreign bonds may offer similar yields and potentially lower risk. Emerging and frontier market bonds offer the potential for attractive returns, roughly in the range of returns from private credit funds we have recommended in the past. In addition to increased liquidity, emerging and frontier market bonds provide diversification away from dollar-denominated assets and lower correlation to developed markets. Of course, while some markets show improving fundamentals, significant risks exist in these markets, including higher credit, political, and currency risks, along with reduced liquidity and transparency. α
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Interesting things I came across this week…
Moody's Downgrades U.S. Government Credit Rating (Bloomberg)
Jeffrey Gundlach on Fed Uncertainty, Private Credit Pitfalls & Waning Momentum of U.S. Exceptionalism (CNBC)
Banks’ Currently Holding $500 billion in Unrealized Losses (Apollo)
1930’s New York Yankees Spring Training Footage (YouTube)
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