What is private credit?
While investors have long relied on bonds and broadly syndicated loans to generate yield, the growing prominence of private credit is expanding the universe of income investing. But what exactly is private credit, and how can investors benefit by allocating to this asset class?
Private credit is rooted in direct one-on-one relationships
Investing in private credit—also known as private debt or direct lending—usually refers to loaning capital to an unlisted company or group of companies, although it can also include privately negotiated loans to public companies. Investors holding public credit—say, a corporate bond or broadly syndicated loan—can generally sell whenever they please. Liquid credit markets serve as a massive, global intermediary between countless borrowers, or issuers, on the one hand, and an even larger number of lenders, or investors, on the other. After the primary offering of a bond or broadly syndicated loan, it can change hands relatively easily, as unnamed investors around the world trade debt daily over the counter. By contrast, as those who’ve taken out a personal loan or mortgage can appreciate, the realm of private credit resides in a direct business relationship. A private credit transaction can involve a single lender who’s more committed to a long-term relationship with the borrower, often lasting through the life of the loan, which can average three to five years. In exchange for this commitment to financing the business, private credit investors usually earn better yields on more customizable terms than investors in comparable public credit.
Private credit differs from bank loans and bonds
|Private credit||Bank loans||High-yield bonds|
|Also known as||Private debt, direct lending||Broadly syndicated loans, leveraged loans||Non-investment-grade bonds
|Coupon rate||Floating (for senior credit)||Floating||Fixed
Source: Mercer, Manulife Investment Management, January 31, 2023.
Private credit spans from senior loans to distressed debt
Private credit isn’t a monolithic asset class. It includes subcategories as diverse as investment-grade private placements, real estate debt, and venture capital loans. Loans mainly fall into two categories: corporate loans (financing companies) and real asset loans (financing things). Two of the more significant opportunity sets for investors in corporate loans include senior credit and junior credit. These strategies invest in loans made to midsize, well-established businesses. What distinguishes senior credit from junior credit is where those loans reside within a company’s capital structure. Real asset loans refer to private debt financing, where the borrower puts up physical assets as collateral in the case of a default. Private originated asset-based loans, secured by real or financial assets, can serve as a complement to both private credit and traditional fixed-income strategies. Meanwhile, distressed debt, opportunistic credit, and special situation strategies involving bankruptcies and restructurings can offer control and capital appreciation opportunities (and associated risks) more typically associated with private equity investing.
Private credit is predominant in North America’s middle market
Unlike their larger-cap peers, middle market companies, those with annual revenues between $10 million and $1 billion, are frequently too small to tap the public bond market, and they’ve historically turned first to commercial banks for debt financing. However, the banking industry has been backing away from middle market lending ever since more onerous regulatory capital requirements were implemented following the global financial crisis.
Direct lending has filled the void left by retreating banks
The bankers’ retreat has created an opportunity for non-bank investors willing to step in and lend directly to businesses. While lending dynamics in the bond markets tend to be driven by price alone, private credit markets are smaller, more fragmented, and less efficient, and the value of human relationships plays a much greater role in making deals happen.
Private credit offers a current yield premium for investors
Source: Cliffwater, as of September 30, 2022; FactSet, as of December 31, 2022. See notes for details.
Potential benefits of investing in an all-weather asset are compelling
Private credit serves as an all-weather asset class given its potential to deliver premium yields, principal preservation, and a measure of protection against rising inflation and higher interest rates.
1 Premium yields
Investors in private credit give up liquidity to pick up yield. While the illiquidity premium associated with directly originated upper middle market loans has ranged from 150 basis points (bps) to 280bps in recent years, it resides closer to 240bps in the current market.1 While premium yields may be the defining feature of the asset class, the potential benefits to investors don’t end with an attractive income stream.
Illiquidity can afford private credit investors a yield advantage
Source: Cliffwater, as of September 30, 2022. Past performance is not indicative of future results.
2 Principal preservation and price stability
Private credit has a history of muted drawdowns amid macro headwinds; it’s also performed well with economic tailwinds. Relative to the liquid credit of larger companies, direct senior loans—which are first in line to get paid in a company’s capital structure—have demonstrated higher recovery rates and lower default and loss rates given the stronger covenants and tighter alignment between equity owners, lenders, and company management.
Better recoveries can drive capital preservation
Market inefficiencies in private credit can also lower leverage levels and make deal structures more attractive for investors. Private credit’s consistent recurring cash distributions can also lower the price volatility of direct loans, which, unlike corporate bonds and broadly syndicated loans, aren’t marked to market.
3 Inflation and interest-rate risk protection
Direct senior loans can offer a measure of interest-rate protection. Floating-rate benefits increase quarterly distributions to investors when interest rates rise, and floors protect investors’ income when interest rates fall. As multidecade record levels of inflation have prompted central banks to hike interest rates, private credit investors have kept pace, unlike their counterparts investing in fixed-rate bonds.
Investors need to be aware of risks
Private credit assets are generally long-term investments, less affected by the short-term price movements of securities listed on the world’s public exchanges. Still, as with any investment, allocating private credit involves a range of risks, including those that can lead to permanent loss of principal.
Because debt investing hinges on issuer solvency, the first risk is credit risk, the risk that the issuer won’t meet its payment obligations on time, in full, or at all. It’s relevant in both liquid and private credit markets. Managing credit risk means generating income with careful issuer selection and vigilant monitoring of issuers. When investors are starving for yield, it’s worth remembering that companies often have little difficulty raising capital through debt issues, even when their fundamentals don’t support them. Credit risk also involves discipline about pricing. Tight spreads can get tighter and wide spreads wider, but managers who have experienced several market cycles have a natural edge over those who have only worked in the latest market regime.
Relative to corporate bond and broadly syndicated loan markets, private credit assets are subject to lower levels of liquidity. Liquidity—the extent to which a position may be sold at or near its net asset value—may be further impaired by heightened volatility, rising interest rates, and other market conditions.
While subscription lines to aid capital calls during the investment period are nothing new, some managers have more recently used them to ratchet up returns; in fact, most senior credit strategies in the market offer a levered option. While leverage can indeed increase the magnitude of potential gains, it can also increase the magnitude of potential losses.
Private credit is moving within reach of more investors
Private credit’s early adopters accessed the asset class through traditional drawdown funds whose high minimum investments generally favored pension plans, insurers, and other large institutions. However, the market is evolving to include feeder funds, interval funds, unlisted closed-end tender offer funds, and other semiliquid structures that can accommodate smaller allocations, thereby opening the segment to smaller institutional and individual investors. Developments in financial technology—specifically, specialized platforms that can consolidate individual investor accounts into a combined pool of capital for general partners—have played a role in broadening access to private credit. While firms offering private credit capabilities now get to diversify their client base and tap high-net-worth and mass affluent capital previously unavailable, more and more income investors, in turn, get to diversify their portfolios beyond corporate bonds and broadly syndicated loans.
1 Cliffwater, September 30, 2022.
Private credit is represented by the Cliffwater Direct Lending Index (three-year takeout yield); high-yield bonds are prepresented by the Bloomberg High Yield Index (yield to worst); bank loans are represented by the S&P/LSTA Leveraged Loan 100 Index (yield to maturity), as of September 30, 2022. Corporate bonds are represented by the Bloomberg U.S. Corporate A Investment Grade Index (yield to maturity); U.S. Treasuries, Singapore governement securities, and Japanese government bonds are represented by 10-year yields, as of December 31, 2022.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other preexisting political, social, and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.
The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.
This material is intended for the exclusive use of recipients in jurisdictions who are allowed to receive the material under their applicable law. The opinions expressed are those of the author(s) and are subject to change without notice. Our investment teams may hold different views and make different investment decisions. These opinions may not necessarily reflect the views of Manulife Investment Management or its affiliates. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.
Neither Manulife Investment Management or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained here. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment strategy, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against the risk of loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.
Manulife Investment Management
Manulife Investment Management is the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than a century of financial stewardship to partner with clients across our institutional, retail, and retirement businesses globally. Our specialist approach to money management includes the highly differentiated strategies of our fixed-income, specialized equity, multi-asset solutions, and private markets teams—along with access to specialized, unaffiliated asset managers from around the world through our multimanager model.
This material has not been reviewed by, is not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions. Additional information about Manulife Investment Management may be found at manulifeim.com/institutional.
Australia: Manulife Investment Management Timberland and Agriculture (Australasia) Pty Ltd, Manulife Investment Management (Hong Kong) Limited. Brazil: Hancock Asset Management Brasil Ltda. Canada: Manulife Investment Management Limited, Manulife Investment Management Distributors Inc., Manulife Investment Management (North America) Limited, Manulife Investment Management Private Markets (Canada) Corp. Mainland China: Manulife Overseas Investment Fund Management (Shanghai) Limited Company. European Economic Area Manulife Investment Management (Ireland) Ltd. which is authorised and regulated by the Central Bank of Ireland Hong Kong: Manulife Investment Management (Hong Kong) Limited. Indonesia: PT Manulife Aset Manajemen Indonesia. Japan: Manulife Investment Management (Japan) Limited. Malaysia: Manulife Investment Management (M) Berhad 200801033087 (834424-U) Philippines: Manulife Investment Management and Trust Corporation. Singapore: Manulife Investment Management (Singapore) Pte. Ltd. (Company Registration No. 200709952G) South Korea: Manulife Investment Management (Hong Kong) Limited. Switzerland: Manulife IM (Switzerland) LLC. Taiwan: Manulife Investment Management (Taiwan)