Throughout history, credit has been the shapeshifter of the capital markets. Loans have been paid back with everything from seeds to servitude and over every timeframe from overnight to over a lifetime. Credit securities can also appear to be something they are not.
Case in point, during the Great Financial Crisis (GFC), securities created from tranches of loans were so complex they obscured the real risk from investors and caused an economic conflagration as a result. But despite Polonius’ best advice in Hamlet (“Neither a borrower nor a lender be”), borrowers and lenders always find each other. Today, this is happening more and more as a result of private credit, and now even retail investors are piling in to get a piece of the action. Will this end well? If the economy slows down, probably not.
Since the GFC ended in 2009, regulations have expanded and capital reserve requirements have grown. Even with the temporary relaxation of some requirements during the COVID-19 pandemic, there has been much higher demand for credit than the supply available from banks. As a result, private credit filled the void and exploded. Since the GFC, private credit in the U.S. has grown from about $250 billion to $1.7 trillion and is projected to nearly double by 2030.
From just $107.88 $24.99 for Kiplinger Personal Finance
Be a smarter, better informed investor.
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
What is private credit?
Private credit represents loans to companies that originate from institutions other than traditional banks. In general terms, they can be categorized in three ways:
- Direct lending to private, non-investment-grade companies (think: riskier companies). Direct lending typically involves senior loans secured by the assets of the company, making them relatively safer in the capital structure.
- “Junior capital,” which can come in different forms but is not secured by assets of the company, so the loan is more at risk in the case of default.
- Distressed debt, which could be seen as the last resort in credit.
Since private lenders are not regulated, they take on risk traditional banks can’t or won’t. They also execute more reliably and work much faster. They don’t run the risk of a deal falling apart after several months because of a risk officer or credit agency throwing up a flag. The average deal size has also gone from $200 million in 2013 to nearly $400 million in 2023. As a result, private lenders have willing customers, and they get the terms they want. This is not necessarily a bad thing for an economy that runs on credit.
Nor is it a bad thing for sophisticated investors who have an appetite for higher yield or asset classes with lower correlation to the public markets. So far, at least, the higher-risk, higher-return tradeoff has been comparable to those in public leveraged loans. However, this might follow the mantra “things work, until they don’t.”
Nevertheless, more than 60% of asset managers say they plan to increase their exposure to private debt. This means it won’t be just pension funds that carve out a piece of their portfolio for this asset class. It will likely be retail investors, too.
Gauging the risk premium
How can retail investors gauge whether the risk premium in this emerging corner of their portfolio is correct? It is not easy. The investments often originate as direct loans or securitized vehicles like collateralized loan obligations (CLOs), which aggregate leveraged loans and structure them into tranches with varying risk levels. So, the retail investors are not getting “loans” as much as financially engineered securities. The CLOs tranches are rated by S&P and Moody’s, who are hired by the issuer.
This is the same arrangement Bear Stearns and others made in the build-up to the GFC. We saw how accurate those ratings turned out to be. Recently, JP Morgan CEO Jamie Dimon commented, “I’ve seen a couple of these deals that were rated by a ratings agency, and I have to confess it shocked me what they got rated… It reminds me a little bit of mortgages.”
Critics of private credit offer plenty of caution for retail investors getting in now. The industry is unregulated and not very transparent. In an economic downfall, there will likely be defaults and loans needing to be amended. The growth of private credit alone could contribute to systemic risk in extreme scenarios, though its direct systemic impact is likely more limited due to regulations enacted after the GFC.
Does the difference in yield between more conventional debt and these private credit deals compensate for that unknown? What happens if inflation remains stubborn, and yields remain high? It will take some courage to believe the spread between a “risk-free” U.S. 10-year Treasury at 5% and an illiquid, opaque private credit vehicle is adequate compensation for the risk.
For now, private credit remains a tailwind to economic growth and a good source of diversification for sophisticated investors who don’t want to pile into more public credit. For the retail investor, Henry IV might be the better inspiration than Hamlet: “The better part of valor is discretion.”
Related Content
- How to Manage Portfolio Risk With Diversification
- Many Mutual Funds Are Converting To ETFs: What to Know
- Expecting a 12% Return on Your Portfolio? That’s Dangerous
- Do You Feel More Negative These Days? Blame the Algorithm
-
Is Trump's Tax Plan Speeding Up the Looming Social Security Funding Crisis?Social Security Social Security's combined retirement funds are running out of cash, and its insolvency date is expected to occur in less than a decade.
-
How to Keep Your Work Friends After You RetireWork friendships can boost teamwork, lift your spirits, and make the job more fun. But when you retire, these friendships can fade. Here's a look at why that happens and what you can do about it.
-
DexCom, GE, SLB: Why Experts Rate These Stocks at Strong BuyWall Street gives these three diverse names Strong Buy recommendations with high potential upside.
-
Here's Why Munis Aren't Just for Wealthy Investors NowBuyers of all levels should be intrigued by municipal bonds' steep yield curve, strong credit fundamentals and yield levels offering an income buffer.
-
Stocks Edge Higher With Nvidia, Fed in Focus: Stock Market TodayThe AI bellwether reports earnings after today's close, while Wall Street is keeping a cautious eye on President Trump's attacks against the Fed.
-
The Smart Way to Retire: 13 Habits to Steal From the WealthyCheck out these practical strategies that anyone can adopt, not just the rich, and get closer to achieving your retirement dreams.
-
Are There Opportunities to Invest in China?Opportunities to invest in China are plentiful and, arguably, shouldn't be ignored in the U.S. Here's where to look.
-
Coulda, Woulda, Shoulda: Are These 5 Stocks Too Overvalued to Buy Now?Investors worried about missing the boat on overvalued stocks need not fret. These five names, while expensive, are still seeing lots of love from analysts.
-
I'm a Financial Planning Pro: Do Your Family a Final Favor and Write Them a Love LetterSpecify your preferences in this personal document that shares your wishes on how you want to be remembered and celebrated. Your family will thank you for easing an emotional time.
-
The Future of Financial Advice Is Human: Gen Z Trusts Advisers, But AI Skills MatterGraduates entering the workforce trust human advisers more than AI tools with their financial planning. But AI can still enhance the client/adviser relationship.
