Private credit has gained significant popularity in recent years, and its investment appeal is well documented online. However, the advantages private credit offers over public bonds are particularly relevant in the post-'Liberation Day' environment, making them worth revisiting.
Floating Rate
A key feature of private credit is that most loans carry floating rates tied to SOFR, so the portfolio is far less sensitive to interest rate changes than public fixed income portfolios. Yields in private credit can be broken down into two components: SOFR + a credit spread.
The SOFR Component: Minimizing Duration Risk
SOFR stands for the Secured Overnight Financing Rate, a benchmark interest rate used in U.S. financial markets. By linking the yield to SOFR, private credit effectively insulates itself from interest rate fluctuations. In contrast, fixed-rate bonds are exposed to duration risk - the inverse relationship between bond prices and interest rates.
If the past several years have taught investors anything, it’s that duration risk is very difficult to manage. The Fed began raising rates in January 2022, pushing the 10-year yield from 1.5% to a peak of 5.0% in less than two years, resulting in steep losses for bondholders.
In 2024, rates once again surprised - this time by not moving. Investors priced in as many as seven rate cuts early in the year and moved into the belly of the yield curve to capitalize on the anticipated pivot, only to have these predictions dashed by persistent inflation.
Now, in the wake of 'Liberation Day,' financial markets are grappling with a cocktail of risks: tariff wars, retaliatory measures, currency debasement, recession concerns, U.S. debt refinancing pressures, and worries about an inflation resurgence. In response, the 30-year Treasury yield jumped over 50 basis points in the past week, driven by basis trade unwinding, foreign selling, and declining market liquidity.
These dramatic movements highlight the amplified volatility and growing interest rate tail risks for bond investors, undermining bonds' traditional role as equity diversifiers. In contrast, private credit is not only less exposed to rate volatility but also stands to benefit directly from rising rates through SOFR catch-up.
The Spread Component: Earning Higher Yields
Even if rates decline, private credit remains attractive due to its typically higher spread compared to public high-yield bonds, driven by several structural factors. These include an illiquidity premium - since private debt isn’t publicly traded, investor capital is locked up for longer periods; risk compensation - many middle-market companies lack credit ratings and public financial disclosures; and the fact that private credit deals are often non-transparent, negotiated directly, customized, and with limited competition. In a low-rate environment, these higher yields become even more appealing.
Using direct lending as an example, the average spread over the past five years has been approximately 650 basis points, well above the 450 basis points seen in public high yield. As of the end of 2024, credit spreads have compressed across the board, but private credit still earns 550+ basis points, while public high yield spread has fallen below 300 basis points.
Risks
While private credit generally has less duration risk thanks its floating-rate structure, it remains as sensitive to credit spreads as public bonds. Wider spreads reduce the value of existing loans for both public and private lenders, while tighter spreads have the opposite effect.
Private credit is often structured to provide more control to lenders in the event of default, mainly through covenants and sponsors. Covenants are written clauses that protect the lender. Sponsors are private equity firms that can support borrowers with extra capital or expertise. These protections help keep private credit default rates lower than high yield bonds, historically around 1% to 3% with recovery rates of 50% to 80%. In comparison, high-yield bonds have higher default rates of 3% to 6% and lower recovery rates of 30% to 50%.
Most public bonds are unsecured, whereas many private credit loans are senior secured. In the event of bankruptcy or liquidation, senior secured lenders are the first to be paid, before unsecured lenders and equity investors.
Summary
Private credit carries significantly less interest rate duration risk than public bonds but remains exposed to credit spread risk and broader economic conditions. When interest rates rise, yields on private credit adjust higher. When rates decline, private credit's higher credit spread becomes more attractive. With top priority in the repayment hierarchy and added protections like covenants and private equity sponsors, private credit has historically seen lower default and loss rates compared to high-yield bonds. Overall, private credit offers an effective way to reduce interest rate sensitivity and volatility, while delivering a meaningful return premium and strong diversification benefits.
