Advisors split on private credit risk following skeptical Moody's report

Should financial advisors fear private credit becoming a “locus of contagion” in the banking system? Are private credit funds vehicles of “systemic stress” that could exacerbate a financial panic?

No, these are not concerns coming from a fictional Chicken Little freaking out that the financial sky is falling. These are real worries spelled out in a report this week from Moody’s Analytics that wealth managers are being forced to take seriously.

Private credit funds have proliferated in recent years, as regulations set in place in the wake of the 2008 financial crisis caused banks to tighten their lending standards. And while private credit firms contend they are superior to banks at lending because they rely on longer-term, institutional capital, the Moody’s report warns that the often-opaque nature of the loans heightens their risk.

“Their opaqueness and role in making the financial network more densely interconnected mean they could disproportionately amplify a future [financial] crisis,” said the Moody’s Analytics study.

It’s a concern shared by Dory Wiley, president & CEO of Commerce Street Holdings, who points out that private credit has become the most “in favor” alternative for advisors in recent years. Wiley said he does worry about the adverse selection issues coming from tighter credit frameworks evolving out of the Great Recession of 2008, adding that if there is a correction “the riskier, more levered private credit strategies are at risk.”

Still, he currently uses his firm’s banking framework and experience to reduce such risks when selecting private credit managers for client portfolios.

“We seek managers that are mostly senior credit or senior stretches and take less leverage. We are looking for spread created by timing and niches, but not by increased credit risk. By doing so, it mimics our banking mind framework and creates 500 to1000 basis points spreads in the private credit managers we invest in,” Wiley said.

David Abella, director of investments at GoalVest, also includes private credit in his portfolios, taking advantage of their attractive yields. He said private credit lenders are able to lend at an attractive spread on top of the 4.33 percent Federal funds rate to reach a healthy expected return of 8% to 10%. 

And while he admits private credit funds can vary in quality, he protects himself by focusing on the more conservative end of the credit risk spectrum and avoids highly leveraged issues. 

“In the event of a recession, the loans may be vulnerable, which is why the initial underwriting is important. Some loans, such as asset-backed, may have less downside and higher recovery in the event of a negative scenario. Our current negative case is for a potential tariff-driven slowdown and a period of stagflation and not a full-blown recession,” Abella said. 

Less liquid, better fit

Elsewhere, Stephen Kolano, chief investment officer at Integrated Partners, does have allocations to private credit, yet primarily for clients where a less liquid allocation is both “suitable and appropriate.”

“Private credit as an asset class has filled a good portion of the demand for credit to businesses that banks once provided and as a result the asset class has grown in opportunity set to represent an asset class that is part of a global asset allocation for the appropriate client. There are opportunities in the private credit space that do not naturally exist in the publicly traded and issued debt,” Kolano said.

Also not frightened by concerns over private credit is Matt Malone, head of investment management at Opto Investments, who sees it as an important addition to a diversified portfolio of alternative investments, particularly for those investors focused on generating a high level of current income.

One important risk the Moody’s report highlights is that of liquidity mismatches. Malone says that is why he scrutinizes a fund's liquidity closely when researching funds.

“While all investors must accept the risk of investment loss, we believe it is imperative not to assume this risk as a result of poorly managed liquidity provisions or leverage facilities. In particular, we are concerned with daily liquid, ETF-style vehicles with significant exposure to largely illiquid private credit,” Malone said.

Private credit holdouts

On the flip side, Jeremy Zuke, financial planner at Abundo Wealth, does not include private credit in client portfolios. He cites higher fees, higher risks, and less transparency as the reasons for keeping him out of the asset class.

“It's an area of the market where sophisticated investors could potentially find some winners, but we don't consider it appropriate for everyday investors building retirement portfolios. Our clients use low-cost, publicly traded, simple fixed income options like government and corporate bond index funds and take their risk with stock index funds rather than higher yielding credit,” Zuke said.

Along similar lines, Charles H Thomas III, founder and president of Intrepid Eagle Finance, does not allocate funds to private credit or private credit funds due to the lack of transparency and elevated costs.

“This approach, like a lot of financial service products, is a fee model for the issuer in search of a problem to solve. When bond ETFs are available for just a few basis points and offer complete transparency, I can't see a reason to look at private credit funds,” Thomas said. 

Finally, Justin Whitehead, founder and CEO of Pebble Finance, shares Moody’s concerns about the growth of private credit, calling it reminiscent of the institutional yield seeking behaviors of investors prior to the Great Financial Crisis of 2008. 

“My concern, similar to the 2000s when increased demand to lend for mortgages led to a lowering of lending standards, is that the same will happen in private credit. When demand for private credit outpaces supply then lending standards will slip to meet the demand,” Whitehead said.