Howard Marks warns that during a downturn, private credit managers may avoid recognizing defaults by simply extending loan terms for struggling companies. This 'extend and pretend' strategy can mask underlying problems, keeping assets marked artificially high and delaying a painful reckoning for investors.
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Large banks have offloaded riskier loans to private credit, which is now more accessible to retail investors. According to Crossmark's Victoria Fernandez, this concentration of risk in a less transparent market, where "cockroaches" may be hiding, is a primary systemic concern.
Default rates are not uniform. High-yield bonds are low due to a 2020 "cleansing." Leveraged loans show elevated defaults due to higher rates. Private credit defaults are masked but may be as high as 6%, indicated by "bad PIK" amendments, suggesting hidden stress.
The increase in Payment-In-Kind (PIK) debt to 15-25% of BDC portfolios is not a sign of innovative structuring. Instead, it often results from "amend and extend" processes where weakened companies can no longer afford cash interest payments. This "zombification" signals underlying credit deterioration.
Private equity giants like Blackstone, Apollo, and KKR are marking the same distressed private loan at widely different values (82, 70, and 91 cents on the dollar). This lack of a unified mark-to-market standard obscures true risk levels, echoing the opaque conditions that preceded the 2008 subprime crisis.
Historically, lower-quality credit cycles involved periods of high returns followed by giving all the gains back in a downturn. Post-GFC, the absence of a sustained recession has allowed private credit to outperform high-quality bonds by 7% annually without the typical "give it all back" phase, masking latent risks.
A consistent 2-5% of Europe's public high-yield market restructures annually. The conspicuous absence of a parallel event in private markets, which often finance similar companies, suggests that opacity and mark-to-model valuations may be concealing significant, unacknowledged credit risk in private portfolios.
Jeff Gundlach argues private credit's attractive Sharpe ratio is misleading. Assets aren't priced daily, hiding risk. When an asset is finally marked, it can go from a valuation of 100 to zero in weeks, exposing the “low volatility” as a dangerous fallacy.
Official non-accrual rates understate private credit distress. A truer default rate emerges when including covenant defaults and 'bad' Payment-in-Kind interest (PIK) from forced renegotiations. These hidden metrics suggest distress levels are comparable to, if not higher than, public markets.
Howard Marks argues that private credit's apparent low volatility during market downturns is not magic but an accounting feature. By not marking to market daily, it mimics the psychological trick of simply not looking at your public portfolio's value, creating a potentially false sense of security for investors.
The massive growth of private credit to $1.75 trillion has created an alternative financing source that helps companies avoid default. This liquidity allows them to restructure and later refinance in public markets at lower rates, effectively pushing out the traditional default cycle.