As interest rates normalise, private credit can help portfolios

Business Times

2 days ago

'HOW did you go bankrupt?' 'Two ways. Gradually, then suddenly.' – Ernest Hemingway, The Sun Also Rises
Often quoted and widely recycled, that response from Mike Campbell – the fictional once-wealthy friend of Jake Barnes, narrator in Hemingway's novel – captures more than just personal financial woes. It's an apt description of how long-running trends unravel – first with subtle shifts, then with violent clarity.
Economist Rudiger Dornbusch put it more clinically: 'In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.'
Both sentiments apply to today's bond market.
For nearly four decades, falling interest rates created a generational tailwind for fixed income. Bonds didn't just pay income, they delivered capital appreciation, diversification, and ballast. Now, that dynamic is breaking down. Prices have fallen, and correlations have flipped. The 40 per cent in a 60/40 portfolio – which comprises fixed income, the supposedly steady part – has become a problem.
But there's one corner of the market that has held steady amid all this instability: private credit.
BT in your inbox
Start and end each day with the latest news stories and analyses delivered straight to your inbox.
Sign Up
Sign Up
From tailwind to headwind
The bond bull market began in 1981, when then-Federal Reserve chair Paul Volcker engineered a brutal double-dip recession to break inflation's back. At the time, the 10-year Treasury yield peaked near 16 per cent.
What followed was a 39-year stretch of disinflation, financial globalisation, and central bank credibility, which drove yields lower and bond prices higher.
For fixed income investors, it was a golden era where being long duration paid off. A simple strategy of buying 10-year Treasuries and rolling them annually would have delivered over 8 per cent in annualised returns from 1981 to 2020.
The Bloomberg Barclays Aggregate Bond Index returned a similarly impressive 8 per cent over that same period. Bonds weren't just a buffer against equity risk; they were a consistent source of performance.
But that golden era followed a very different one. In the 35 years before 1981, yields climbed steadily and were far more volatile. Bondholders clipped coupons while watching principal values erode. Price appreciation simply wasn't part of the fixed income playbook. There were no 'total return' bond funds because, frankly, there was no total return to chase.
The middle ground
We're not heading back to the 1970s. The US economy is structurally stronger; the Fed is more disciplined; and the lessons of the Volcker era still hold.
But we're also not in a new bond bull market. Instead, we're in a period of normalisation where rates are higher than the recent past but still lower than long-term historical norms.
Following the global financial crisis (GFC), the Fed supported the bull market in bonds with quantitative easing. But in 2022, the central bank began reducing its balance sheet, and by continuing to let its Treasury holdings mature without reinvesting the proceeds, it has kept upward pressure on rates with the increased supply.
Increased fiscal spending and higher deficits bring uncertainty and expectations of higher future Treasury issuance, increasing the term premium demanded by investors.
This middle ground comes with consequences: greater volatility and interest rate risk, less price support, and less reliable diversification.
We've written extensively about how rising rates scramble traditional asset class relationships. In 2022, when the Fed launched its most aggressive hiking cycle in decades, the longstanding negative correlation between stocks and bonds broke down. Since then, the two have moved in the same direction in 31 of the past 40 months, nearly 80 per cent of the time – a dynamic that undermines the very foundation of balanced portfolios.
If you believe that we're beginning a normalised inflationary regime, different from the sub-2 per cent post-GFC era, the unreliable stock-bond correlation is likely to continue. Based on historical data, the stock-bond correlation becomes positive beginning at 2 per cent inflation, strengthening as inflation increases.
It's not just the lack of diversification that's troubling. Bond market volatility, once rare, is becoming routine as a result of policy uncertainty. Modest data surprises or policy comments now trigger exaggerated moves across the yield curve, and central banks retreating as a steady source of demand has reduced market liquidity that helped keep bond prices stable and predictable.
Once major buyers of Treasuries, central banks are pulling back as rising yields in markets such as Germany and Japan make US Treasuries less appealing, especially after factoring in currency hedging costs. At the same time, heightened uncertainty has caused the term premium to resurface, hitting an 11-year high in May.
Investors are demanding more compensation for interest rate risk, reflecting a structurally different regime. In April, high-yield bond prices suffered their steepest drop since the early days of the pandemic – second only to March 2020.
Private credit's quiet consistency
While public credit markets have endured drawdowns and dislocations, private credit has functioned as intended, providing financing to borrowers and liquidity to private equity sponsors without disruption.
That resilience is showing up in the data. April's tariff-driven volatility caused liquid credit spreads to swing sharply – widening in one of the most significant moves in history, before recovering around 71 per cent by early May.
In contrast, the private credit market operated as usual, providing a stable source of funding for companies throughout the turmoil.
Private credit's advantages are structural. In a world of higher rates and unpredictable correlations, it can offer insulation from policy shifts, with floating rates and lower correlation to public markets.
The private credit model brings lenders (investors) directly to borrowers in a 'farm to table' model, reducing the role of bank intermediaries and giving back this spread to investors.
The strategy's floating rate nature reduces exposure to interest rate risk, leaving credit risk as the primary concern – one that experienced managers seek to address through careful underwriting, active portfolio management, and within private investment-grade credit, a focus on first-lien senior secured debt.
Historically, private credit has delivered steady cash flows, limited volatility, and a reliable alternative source of return.
Importantly, the private credit space extends far beyond traditional direct lending. Today, the total addressable market for private credit exceeds US$30 trillion, a significant expansion from less than US$100 billion prior to the GFC.
Private asset-backed financing has become a vital source of capital for companies in high-growth areas such as energy, digital infrastructure, and transportation, while providing investors with hard asset collateral, amortising cash flows and over-collateralisation.
The continued growth of these sectors may expand the asset-backed financing opportunity and potentially give investors an increasingly diverse mix of private credit strategies, providing more resilient portfolios.
That's good news for investors, because as they confront the 40 per cent problem – the end of easy returns and automatic diversification from public traditional fixed income – they'll need to adapt. In a portfolio that's no longer self-balancing, we believe that tools like private credit are essential.
The writer is chief investment strategist, Blackstone Private Wealth Solutions