Private credit is risky, but is it rewarding?
Private credit targets higher returns through higher risk. But research shows investors haven’t seen value over the full cycle since the GFC.
Bond king Bill Gross, then of Pimco, was a cold voice of reason during the 2008 financial crisis, pointing out matter-of-factly that the interest rate premium paid by riskier credits did not match the likelihood of those credits failing.
“When the premium paid for the riskiest debt is only 2.5 percentage points over the safest and the historic default rate of that debt is 5%, and about 60% of the principal is lost in a default, any loan made at the rates prevailing [in 2006] would lose 3% over the life of the loan,” he said. “High-yield lenders were giving away money.”
High-yield lenders are back, only now they’re called private credit. The critical issue isn’t whether private credit assets are riskier — everyone accepts they are — but whether the interest rate premium charged on that credit justifies the risk and provides an adequate return for investors.
Roughly speaking, bank loans to major private credit sectors like commercial real estate development and medium-sized businesses are priced in the low single digits. But the banks have increasingly pulled back from this space due to capital requirements and a preference for simpler lending, such as mortgages.
