Central banks note limited risks on non-bank lending

Central banks, including the Reserve Bank of Australia (RBA) and US Federal Reserve, view the financial risks associated with private credit investments as relatively low, particularly when compared to traditional debt markets, despite newspaper headlines suggesting otherwise.

The Reserve Bank of Australia recently estimated that Australia's private credit market is worth approximately $40 billion, accounting for 2.5% of total business debt. In the US, private credit has experienced substantial growth since the GFC and now accounts for around 15% of the total outstanding debt of private companies. According to the US Federal Reserve,[1] the aggregate value of private credit is now comparable to that of leveraged loans and high-yield corporate bonds.

Low default rates noted by central banks

As private credit markets have grown, central banks have examined the industry and the associated risks. Both the US Fed and RBA have given the private credit sector a cautious stamp of approval, stating it provides funding to businesses where needed and that the financial risks associated with the sector are relatively low compared to other debt markets.[2]

The RBA has stated: “Default rates in private credit have been relatively low and less frequent in recent times relative to comparatively risky investments, such as in the syndicated loan or high-yield bond markets (Cai and Haque 2024). The sector has greater capacity than other forms of lending to postpone losses and defaults due to the bilateral nature of lending agreements. This has made it more resilient thus far in the cycle,” the RBA said in October.[3]

While the RBA considers the direct risks to financial stability from private credit to be low, transparency issues remain a concern. This view is shared by ASIC which is closely monitoring the sector due to concerns about leverage visibility and potential systemic risks as private credit markets continues to grow. Vado Private welcomes regulation that results in greater visibility and transparency for investors; enabling investors to look under the hood will ultimately lead to greater confidence in the private credit market.

Same views from the US Fed

In similar narrative to the RBA, the US Federal Reserve has indicated that “financial stability risks from private credit funds appear limited”[4] and that direct lending default rates have generally been low, compared to the broadly syndicated loan market or high yield bond market.[5]

According to the US Fed: “Low default rates can be attributed to (i) low interest rates for most of the past 10 years and (ii) periodic monitoring of borrowers through loan covenants, as well as the ability to renegotiate flexibly with a relatively small group of creditors when borrowers are in distress.”

Low risk, relatively high returns, appeal to income seeking investors

Private credit has delivered attractive returns, according to central banks. “Over the past decade, the asset class, particularly direct lending, has generated higher returns than most other comparable asset classes, including 2-4 per cent over syndicated leveraged loans,” the US Fed said in a report earlier this year.[6] “Borrowers have been willing to pay a premium for the speed and certainty of execution, agility, and customisation that private lenders offer.”

The US Fed has also pointed out that the largest investors in private credit funds are pension funds, insurance companies, family office, sovereign wealth funds and high net worth individuals^. “These institutional investors invest in private debt due to various factors such as portfolio diversification, low correlation to public markets and relatively high returns.”

In Australia, large superannuation funds including Australian Retirement Trust, Aware Super, AustralianSuper and Hostplus are increasing their allocations to private credit significantly. These funds are attracted to the higher risk adjusted returns from private credit compared to other fixed income investments.

With private credit attracting institutional investors, retail investors and retirees should feel reassured by these endorsements from central banks.

For those seeking income, the private credit market offers a good opportunity to reap relatively high yields with periodic monthly oncome, offering appealing fixed income diversification opportunities beyond traditional investments like bonds. 

For everyday investors, private credit could make up a small allocation depending on their comfort with less liquid investments and need for income. The percentage of a portfolio allocated to private credit will vary depending on an investor’s goals, risk tolerance, and investment horizon.