Navigating Public and Private Credit Markets: Liquidity, Risk, and Return Potential

Ongoing innovation in technology and product design should continue to support liquidity and increase trading volumes in public markets, in our view.

Average daily trading activity for U.S. dollar investment grade (IG) bonds in 2024 is $34.8 billion as of 25 June, according to J.P. Morgan. As shown in Figure 2, only a small percentage of IG bonds don’t trade each month.

Weighing opportunity costs, alpha, and liquidity premium

When moving from public into private markets, investors typically give up some liquidity in pursuit of long-term returns. It’s important to assess the potential gains versus some inherent risks.

By locking up capital in private assets, an investor forgoes active opportunities to trade that capital. Alpha often comes from trades arising out of market dispersion or buying undervalued assets. The cost of providing liquidity is the net present value of these missed opportunities. Relatedly, illiquid portfolios can’t easily be rebalanced after a sell-off or a rally.

Adding illiquid assets also increases the risk of not having enough liquid assets for spending needs. A liquidity premium is needed to offset the expense of protecting the portfolio against this risk.

Based on these risks and associated costs, we estimate long-term illiquidity costs to be around 200 basis points (bps) a year. That includes the cost of lost alpha from active management of fixed income portfolios, the cost of the inability to rebalance portfolios, and the cost of liquidity shortfalls for unexpected liquidity needs.

Meanwhile, the compensation for providing liquidity is declining across both public and private credit markets as more capital chases too few opportunities. New investments are entering at potentially unattractive valuations, with corporate spreads across public and private credit markets near record lows.

In public corporate credit, liquidity premiums and risk premiums have declined to what we would consider less attractive levels. As a result, we have shifted our active public fixed income strategies to areas that we believe offer healthy liquidity and risk premiums, such as agency mortgages and senior structured products. Such ongoing active adjustment has the potential to lead to superior returns than would be expected based on initial spread.

Similar to the tightening that has occurred in public investment grade spreads, the liquidity premium in investment grade segments of private credit markets has tightened to less than 100 bps. We believe that level is insufficient relative to the opportunity costs associated with rebalancing, lost alpha from public fixed income, and potential costs of cash shortfalls.

Additionally, many private investment grade issuers are also able to access more liquid public fixed income markets and thus are only willing to pay a small additional spread to borrow capital in private markets for certain capital structure nuances that affect credit quality. Adjusting for credit quality differences between public and private investment grade issuers, the excess spread of less than 100 bps becomes even less attractive.

When we shift beyond investment grade and compare the broadly syndicated loan market versus private corporate credit (middle market direct lending investments), we observe something similar. The spread premium for private corporate direct lending relative to broadly syndicated loans has tightened from about 400 bps three years ago to 193 bps in 2024 (see Figure 3), according to PIMCO calculations based on Lincoln and LSTA data.

Weighing the shrinking liquidity premium against the associated costs to provide that liquidity suggests that investors today are receiving inadequate compensation for locking up capital in certain private credit areas, particularly those where incentives are to raise capital and deploy funds immediately.

Credit quality differs across public and private markets

Investors should also take into account the differences in average credit quality between public and private credit markets:

• Credit quality and free cash flow generation: Private corporate credit is heavily concentrated in sectors such as technology and health services, which are susceptible to AI disruption and changing business conditions (for more, see our latest Secular Outlook, “Yield Advantage”). These are typically smaller, leveraged companies financed with floating-rate debt, making them vulnerable to sustained high interest rates, economic slowdowns, defaults, and lower recoveries. Higher interest rates have started to affect interest coverage ratios (how well earnings cover concurrent interest payment expenses) for private companies much more than in public markets. The percentage of private corporate direct lending borrowers with fixed charge coverage ratios below 1x has risen from 15.9% two years ago to 40% this year (see Figure 4). This means 40% of private credit borrowers (size weighted) are not producing enough cash flow to service all debt, taxes, and capital spending needs. If interest rates stay elevated for longer or economic growth slows, these borrowers would be more vulnerable to further increases in leverage, declining credit quality, and higher expected losses. Such a credit cycle would likely create attractive opportunities to provide new financing with preferable terms to new investors.

• Private equity dynamics: Private equity owners are experiencing longer hold periods and valuation pressures due to the sharp rise in base rates, which has diminished their willingness and ability to support portfolio companies. Furthermore, the influx of new entrants into the space has weakened the importance of the sponsor-lender relationship and led to a deterioration in private credit documentation.
• Market shifts and innovations: Many higher-quality companies have been moving back to public markets, leaving private credit portfolios with selection bias issues. Private credit innovations like synthetic payment-in-kind (PIK) structures – which allow interest payments to come from other borrowings – may merely mask borrower stress as higher rates pressure free cash flow in older investments.

Balancing the risks and costs against potential investment returns within private markets more broadly, we see many attractive options for investors who can manage around illiquidity – but careful selection within sectors and companies is key (learn more in our recent video, “Unlocking the Power of Private Credit”).

Conclusion

PIMCO’s global platform spans public and private markets, and we are constantly seeking relative value opportunities among asset classes, sectors, and regions. Not all areas of public fixed income or private credit markets will be permanently attractive or unattractive. There will always be opportunities across different segments of both markets. Investment decisions should reflect the most up-to-date valuations and quality assessment across the entire opportunity set.

Based on current relative valuations and market conditions, we strongly believe there is tremendous value in high quality, liquid public fixed income. Starting yields look very attractive when compared with most alternatives across the risk and liquidity spectrum.

With inflation falling toward central banks’ targets, high quality fixed income may also offer an attractive, liquid hedge to risk assets. Additionally, private investments in less trafficked areas – such as asset-based lending and opportunistic financing – that have adequate liquidity compensation, superior credit quality, and strong asset protection may offer attractive value to investors.