Private credit: An investment perspective

Private credit lenders are mostly institutional investors, such as private credit funds, pension funds and insurance companies. A major segment of the market is direct lending, where private credit funds lend directly to mid-sized companies. The private credit market spans a wide range of lending, including secured loans, mezzanine debt, distressed debt and special situations.¹

Let's compare private credit to the bond market:

• Size and profile – Many private credit borrowers are too small or not well-known enough to access public bond markets cost-effectively.
• Customization – Private credit deals are often tailored to the borrower’s needs, unlike standardized public bonds.
• Speed and confidentiality – Private credit can offer faster execution and greater confidentiality compared to public issuance.
• Covenants and control – Private credit lenders may negotiate tighter loan covenants and have more influence over the borrower.

The private credit market has expanded access to investors in recent years, shifting beyond its typical focus on institutional and high net-worth or accredited investors. Growth in the market has included "liquid alternatives," offering investors private credit exposure through ETFs and mutual funds, without requiring investors to be accredited.

Now let’s consider some of the potential benefits for investors in private credit investment funds.

Potentially higher yields than bonds

Investors have seen muted returns for bonds since the era of low interest rates ushered in by the global financial crisis of 2008 through 2009. Bonds have particularly disappointed in the 2020s, marked by a collapse in 2022 that saw U.S. aggregate bonds lose 13% and U.S. long-term Treasury bonds lose 30%.2 In this context, investors have been drawn to private credit by the prospect of much higher yields, sometimes in the range of 8 to 10%. Investors may also hope that this lending comes with less duration risk than with government bonds and with more carefully selected credit risk than broad exposure to high-yield bonds.

Potentially lower volatility than stocks

U.S. and Canadian stock market returns have been excellent in the 2020s but with high volatility, including the pandemic crash of 2020, the technology crash of 2022 and the tariff crash of 2025. Investors who are concerned about this level of volatility may be attracted to private credit, potentially targeting a risk-return profile somewhere between that of equity and fixed-income, while seeking to avoid the sharp drawdown risk of stocks.

Opportunity to improve risk-adjusted performance

Private credit, like other alternative investments, can offer relatively low positive correlations to public stock and bond markets. Part of a portfolio moved out of bonds and into private credit investments may have been less exposed to rising rates that particularly affected long-term sovereign bonds in 2022. Part of a portfolio moved out of stocks and into private credit investments may have been less exposed to the stock market's gyrations in the 2020s. This diversification has the potential to smooth out portfolio returns and improve risk-adjusted performance.

Now let’s consider some of the risks for investors in private credit investment funds.

Difficult to understand risks

The risks of a private credit fund may be difficult to understand, consisting of a multitude of individual lending agreements with privately-held companies. Unlike with a bond index fund, interest rate and credit risk exposure may be difficult to ascertain for the fund as a whole. These risks may also be difficult to anticipate during periods of market stress, such as rising rates or global recessions.

Relies on active management

Since the lending risks of a private credit fund can be difficult to understand, investors have to place a high level of trust in the skill and integrity of the fund's managers. Private credit lending almost by definition means active management in markets that the public would not be able to access. A typical result of this set-up, as seen in other areas of alternative investments, is a wide dispersion of returns between highly skilled and unskilled managers. In some cases, the dispersion of returns can be extremely wide, such as between a skilled and unskilled manager of distressed debt.

It can be difficult to identify skilled managers in advance, because of survivorship bias — where reported returns are based only on successful lenders that survive — and backfill bias — where lenders may incubate a lending program for years before launching a private credit fund, then backfill the fund's performance record with results achieved during the incubation period.

Can be illiquid

Private credit funds may involve lock-up periods of multiple years and redemption limits or gates, where the lender may prevent investors taking their money out of the fund during stressed market conditions. Some larger funds may suggest their deal flow is so large that they would not need to impose redemption limits. Yet if the investment can be redeemed on demand, investors might reasonably ask why the investment would have a liquidity premium — a higher expected return than a more liquid investment. 

Can be correlated with stocks

Part of the appeal of private credit investments is a relatively low correlation to public equity markets. This may hold up in good market conditions but may break down in bad market conditions. It is not clear that companies borrowing in the private credit market are larger or more creditworthy than issuers of high-yield bonds — and the high-yield bond market can become highly correlated with equity markets during a downturn.3 In private credit lending, the credit risk is always there — but its visibility is reduced by the lack of quotable market pricing for the underlying loans and by redemption limits that prevent investors withdrawing funds during periods of market stress.

Lack of track record

While some large private credit lenders have been around for decades, there's no long-term track record for private credit as an asset class. Investors in U.S. stocks or Treasury bonds can see how the asset class behaved during the Great Depression of the 1930s, the stagflation of the 1970s or the global financial crisis of 2008 through 2009. In contrast, investors in private credit can only guess at how an investment would have performed during these times, depending on the type of lending and skill of the manager.

Private credit may be of interest to investors who are seeking potentially higher yields than bonds, potentially lower volatility than stocks and an opportunity for improved risk-adjusted performance. 

However, private credit is not for everyone. Investors in private credit funds have to accept a number of risks. They may not always have a clear view of interest-rate and credit risk. They have to place a high level of trust in active fund managers. They may not always be able to cash out their investments on demand. They can’t always expect a low correlation with stocks, and they don’t have a long-term track record of performance for the asset class.

In the past, private credit has been a relatively niche market, made up of investors who care enough about the benefits of private credit and who can accept its risks. This helps to explain why private credit has traditionally been restricted to accredited investors and has only recently become available to the public through ETFs and mutual funds.

Given the risks involved, investors may ask if they can achieve the benefits of private credit investments in other ways. For example, investors can reduce equity market volatility by emphasizing lower-volatility or dividend-paying stocks. Investors can increase income by using covered call strategies or by applying leverage to high-quality bonds. And investors can target performance somewhere between that of equity and fixed-income by adjusting their asset mix.

From this perspective, thinking about the potential benefits and risks of private credit can be a useful portfolio exercise, regardless of whether investors allocate to private credit investments.

• Overview: Private credit is when businesses borrow money directly from investors, rather than from banks or the bond market. Compared to the bond market, private credit allows smaller companies to borrow with more flexible terms, faster funding and greater discretion, while enabling lenders to negotiate loan covenants that fit the specific risks of the borrower.  
• Benefits: Private credit investments have grown significantly in recent years, as investors seek alternatives to subdued bond returns and high levels of equity market volatility. Private credit investments may offer investors an opportunity to diversify beyond public equity and debt, potentially improving a portfolio's risk-adjusted return.
• Risks: The risks of private credit investment funds can be hard to understand, based on individual lending agreements with a multitude of privately-held businesses. Private credit relies on active management to manage credit risk, can be illiquid with redemption and other limits, can be correlated with stocks during equity market downturns and lacks a long track record, compared to major asset classes.
• Investors: In the past, private credit has been a relatively niche market, made up of investors who care enough about the benefits of private credit and who can accept its risks. Given the risks involved, investors may ask whether they can achieve the benefits of private credit investments in other ways, such as by selecting different types of stocks, bonds and options, or by adjusting a portfolio's asset mix.

1. Mezzanine debt sits between senior debt and equity in a company's capital structure. Mezzanine debt may include relatively high interest rates, warrants or conversion options to equity. Companies often use mezzanine debt to finance acquisitions or growth.
2. Performance based on iShares Core U.S. Aggregate Bond ETF (AGG) and iShares 20+ Year Treasury Bond ETF (TLT).
3. The U.S. high-yield bond market dropped by 11% in the technology crash of 2022 and by 17.6% in the financial crash of 2008. Performance based on iShares iBoxx $ High Yield Corporate Bond ETF (HYG).