Sources of Premium Return
The sources of higher interest rates in the private debt market are:
Investing in the lower end of the investment grade scale is safer in the private debt market than in the public bond market because of the stronger covenants, active management and direct investor/borrower relationship.
Private debt is a buy and hold investment that is not intended to be traded.
Extra basis points of yield are obtained without additional risk from such features as custom designed loans, confidentiality, lower transaction costs, etc.
An important (and underappreciated) source of lower risk and higher realized return in the private debt market is the higher recovery rate on defaulted investments. Private debt market recovery rates are in the mid-80% range. To put the importance of the higher recovery rate into perspective, the loss ratio in a 3.0% default scenario would be 0.45% for private debt, much lower than a 1.85% loss ratio experienced in the public bond market.
The higher recovery rate in private debt is due to the strong covenants, the ongoing direct investor/borrower relationship and, in most cases, the objective of obtaining a ‘going concern’ solution to defaults that restores the borrower to financial health.
In summary, the investment grade private debt market outperforms the public bond market because it starts with a higher yield and loses fewer basis points due to defaults resulting in a higher rate of return with a lower level of risk.