Private credit vs corporate bonds: is a storm brewing?

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Investors are nervous. There are few other ways to read the latest gains in gold – above $3,650 per ounce for the first time this week – or the big moves in long-dated government bonds. Yet some markets look remarkably unperturbed.

Take credit spreads – the gap between the yield on government bonds and corporate debt – which tend to blow out at times of stress.

Spreads for US investment-grade bonds are instead at their tightest since 1998, barely 0.8 percentage points (pp) above the yield on comparable Treasuries. Eurozone investment grade bonds are similar; they have been tighter at times (eg, 2007 and 2018), but remain very low. Spreads for non-investment grade bonds (known as high-yield) are around 2.9pp, a bit higher than they were earlier this year in both the US and European markets. But they are still right at the bottom of their long-term range, and below the 4%-plus area they hit in April – which was not itself exceptionally high.

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The growth of private credit

One theory holds that spreads are tight because government bonds are getting riskier and no longer offer a real “risk-free rate” to benchmark corporate bonds against. Some argue that top-grade corporate credit could trade on lower yields than governments (the spread on US AAA-rated bonds is around 0.3pp).

This feels like a stretch. The most likely escape route for governments is to have central banks buy bonds at low yields – a precedent set under quantitative easing. That is probably inflationary and inflation will hurt low-yield corporate bonds. If you expect this, you should demand higher yields, not settle for less.

Another argument with high yield, in particular, is that the corporate bond universe is of higher quality now. The growth of private credit – the hottest area in alternative assets over the past few years – means that lower-quality borrowers have migrated there to get more favourable terms. That has left the better borrowers in bonds. There is probably some truth in this, but spreads still look so tight that they don’t provide much compensation for risk.

Of course, tight spreads also explain why higher yields in private credit have proved so attractive. The challenge with private credit is that it is by definition less public, so it’s harder to have a clear picture of the market and how much risk investors are taking to earn, say, 200pp more yield from something much less liquid.

On the face of it, default rates remain low – around 1% according to a recent paper by ratings agency S&P Global. But this relies on a narrow definition of default and ignores selective defaults, such as converting cash interest into more debt, repayment holidays or extending debt maturities. Include those and defaults have been much higher, says S&P, despite the benign environment. Data from other analysts paints a similar picture. One has to figure there will be a reckoning here when the cycle turns, making low credit spreads in bonds a dangerous reason to reach further for higher yields in private credit.

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Cris Sholt Heaton is the contributing editor for MoneyWeek.

He is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is experienced in covering international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers.

He often writes about Asian equities, international income and global asset allocation.