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Understanding Private Credit Markets

Alternative Credit Strategist, Kyle McCarthy explains private credit markets and why it plays an important role in portfolios.

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Text on screen: John Valtwies, Account Manager

Valtwies: Kyle, can you take us through what exactly are private credit markets and some of the instruments?

Text on screen: Kyle McCarthy, Alternative Credit Strategist

McCarthy: Private credit refers to any form of borrowing that's outside of the traditional banking sector. So by definition, these are loans that are private, meaning that they're illiquid. So a non-bank lender or an alternative lender, such as PIMCO, would originate a loan specifically for a given borrower in a bilateral fashion, and then typically hold that loan to maturity, because, again, they don't typically trade.

The key characteristics for a private credit loan are really threefold. The first is that they're floating rate. The second is that they're senior-most in the capital structure, which means they get priority payments. And third, they're secured by collateral, meaning that they're backed by some form of collateral that secures the loan itself, and that also improves the downside protection as well.

How we define the space is quite broad. So we think of it in four different credit sectors. You have private corporate credit, so private corporate loans. You have commercial real estate debt. You have specialty finance, which is things like consumer-oriented credit – so student loans, auto loans, other forms of asset-backed credit, like aircraft leasing, for example. And then you have residential mortgages as well, so pools of single-family mortgages that a consumer would borrow as well.

So the universe is quite broad and diverse, but those characteristics are pretty consistent across all forms of private credit that I mentioned.

Valtwies: Can you tell us a little bit more about the borrowers? After all, this market is a $2 trillion size made up mostly of corporates sitting in around about $1.5 trillion. But can you give us some more colour on those borrowers?

McCarthy: Yes, I think there are really three main borrower types. You have corporations, so corporate borrowers looking for a more customized debt package or borrowing that they're seeking. You have commercial real estate owners and operators that may be looking to finance a commercial real estate asset, such as an office tower, or an apartment complex, an industrial property, student accommodation, etc. And then you have consumers where again, I mentioned things like student loans, auto loans, credit cards. That's a large and growing market as well on the private side. But ultimately, I would say it boils down to those three main investor types.

Valtwies: For investors, this is a new asset class that they may not be as familiar with. Why is private credit an important part of a broader portfolio?

McCarthy: Yeah, it's a good question. There are a lot of benefits in investing in private credit, though I would say there are three key ones. The first one is the attractive income potential that these private credit positions offer investors. Number two is more downside protection. And three is diversification. So I'll hit on all of those very briefly.

On the potential for higher income side, because these loans are generally illiquid, they have what we call an illiquidity premium. So they tend to offer a higher income or higher yield than what you would typically find in the public markets, to compensate investors for that illiquidity risk. So over time, what we see is they tend to yield a bit higher and therefore offer higher return potential, higher income potential. That is one of the primary benefits of investing in this asset class.

The second, as I mentioned, is downside protection. So we hit on this earlier, these loans are typically senior secured in the capital structure, which means they are well protected by more subordinated forms of either debt or equity, which means if you're sitting at the top, you have priority of payments. And if there is some sort of a credit event or defaults, you have a lot of protection beneath you. Basically, other investors that are taking those first losses and you're backed by collateral in many cases. So, you know, commercial real estate is a good example where a loan may be backed by an apartment complex. You have a physical building that is backing the loan itself that you could take over in the event of some sort of a credit event.

In terms of diversification, again, in terms of the key characteristics of the space, because these loans are floating rate, it's very different from the fixed interest market, which has a lot of interest rate sensitivity. We saw this when private credit performed quite well, where assets that were more fixed interest or had some duration exposure did poorly. And so it offers a bit of diversification relative to traditional fixed income. And because the borrower types are pretty unique and there are high barriers to entry in this market as well, this market is also often very complementary to other forms of either credit or even equities, and tends to have a lower correlation to those types of asset classes as well.

So again, it's higher income potential, it's downside protection, and diversification.

Valtwies: So when we look at private credit, PIMCO has a large focus on this universe. Can you take us through PIMCO's approach to looking at private credit markets?

McCarthy: I think one of the things that we do pretty uniquely here at PIMCO is we define private credit very, very broadly. So we talked about the different forms, whether it's corporate borrower, commercial real estate, residential mortgages, specialty finance. Many other players in the space will address this market very singularly focused on just one of those sectors.

We take a much broader view and really a top-down perspective from a macro point of view in terms of how we want to allocate across those different spaces. So it really opens up the opportunity set and allows us to pivot depending on where we are in the cycle and where we're finding opportunity. So said another way, we're not bound to just one single opportunity set, but we can really allocate away if we find something unattractive and are finding better relative value or better being compensated for risk elsewhere.

So that I think is a key pillar of our platform. And we've really based our organic growth over many years from our fixed income expertise. So there is a direct corollary to everything that PIMCO has done historically for many, many decades – investing in traditional fixed income in terms of the underwriting, in terms of their risk management, in terms of, you know, understanding the collateral and the structuring of these loans, and then asset managing them over time. We apply that same investment philosophy to all of these private markets as well.

So the key is that investors get more diversification, which we think leads to more stable returns over time because it's a much broader lens, a broader definition of private credit.

Valtwies: Well, thanks Kyle. To learn more about private credit, the market or the investment solutions that we offer, please get in touch with your PIMCO account manager.

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