Private Credit Mania Shrugs Off Mounting Risks In Junk-Bond Market

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(Bloomberg) -- Private loans are most likely to perform best in credit as other categories of risky corporate debt face more defaults, according to the latest Bloomberg Markets Live Pulse survey.

More than 40% of 387 survey respondents said private credit will outperform over the next 12 months. And that's despite a majority also predicting weaker returns and lower quality in direct loans, as competition between lenders intensifies.

Private credit generally involves lending directly to companies at higher rates than publicly-syndicated bond and loan markets offer. Those making such loans say that they can glean more information about a borrower by going direct, and secure better claims on assets if it struggles to pay back.

Because the debt is usually offered at a floating rate, investors benefit when underlying interest rates stay high. It also doesn't trade very much — if at all — making the loans hard to value, but also less volatile in investors' portfolios when global markets get choppy.

US junk bonds and leveraged loans have returned about 11% over the last 12 months, compared with a 30% gain in the S&P 500. Private debt investors expect to generate returns in the high teens without the volatility typically seen in publicly-traded debt and equity markets.

The $1.7 trillion private credit boom is drawing criticism — and the attention of regulators — for its lack of transparency and perceived mispricing of risk. But the preferences highlighted by the survey show investors positioning for a protracted period of elevated base rates and volatility in other asset classes.

The worry for some investors is that it's hard to see when borrowers fail to pay on time because lenders can negotiate ways to keep them afloat. That's a particular concern when high-risk companies face bigger debt payments, slumping earnings and a looming maturity wall. Some fear it's a bubble that could burst, inflicting pain elsewhere.

On that note, most survey respondents predict that private credit margins and covenant quality will decline over the next 12 months as public markets compete more fiercely for business. High-yield bond and leveraged loan issuance has picked up this year, with demand from yield-chasing investors helping to make those markets more attractive to US corporate buyers.

Even with all these potential pitfalls, private credit is a safer bet than junk bonds if the US economy stumbles, a majority of survey respondents said.

In addition, the survey highlights a bearish outlook for high-yield bonds, with spreads on the debt predicted to widen to about 450 basis points over Treasuries in 12 months. That compares with just above 310 bps currently and would mark a selloff to levels last seen in the middle of last year, around the time of the 2023 regional banking crisis.

That risk-off move in more public debt markets reflects survey respondents' expectations of a rise in missed debt payments by cash-strapped companies. About 90% of survey participants predict a default rate will keep rising, after it surged to about 4.7% in US junk bonds, according to S&P Global Ratings. Still, most don't expect that to impact financial markets more broadly.

The other lurking danger for credit investors, commercial real estate, is only expected to escalate. Asked whether CRE stress will deteriorate over the next 12 months, roughly three quarters of respondents said yes. Of those expressing concern, about half think it will only hurt banks, while the rest also expect it to rip through other asset classes. Only about a quarter of survey participants expect it to bottom out over the next year.