J U LY 2 0 2 4

AUTHOR

Navigating Public and Private
Credit Markets: Liquidity, Risk,
and Return Potential
Comparing public fixed income and private credit markets involves weighing
factors related to liquidity, transparency, credit quality, risk premium, andopportunity costs.

Mohit Mittal
CIO Core Strategies

KEY TAKEAWAYS:• Public markets offer potentially healthy opportunities for excess returns (alpha) given
structural inefficiencies and macroeconomic volatility driven by divergent global
growth and inflation paths. Public fixed income liquidity remains robust, aided byinnovations like ETFs and portfolio trading.
• Less-liquid investments like private markets should offer an excess premium – which
we estimate to be about 200 basis points – to compensate investors for potential
lost alpha from active management in public fixed income, opportunity costs
associated with the inability to rebalance, and potential costs of cash shortfalls forunexpected liquidity needs.
• Liquidity premiums have compressed in both public and private credit markets, withlower-quality segments of each facing elevated vulnerability to economic slowdowns
and higher interest rates. Public markets offer opportunities to pivot to more
attractive sectors.
• Asset selection matters. Following significant repricing in rates globally, we see
tremendous value today in high quality, liquid public fixed income – which canoffer attractive yields and serve as a hedge against risk assets – as well as inselect private investments in less trafficked areas such as asset-based lending andopportunistic financing.

Public and private credit markets can bothTwo concepts central to comparing theseoffer attractive investment opportunities

markets are liquidity and alpha. Liquiditythat reward careful analysis acrossmeasures how easily financial assets can beregions, sectors, and securities. As anbought or sold without severe price changes.

active daily participant in both of these

Alpha refers to the opportunity for excess

markets, PIMCO observes that there areinvestment returns beyond the performance

key structural differences between them asof the broader market.

well as significant sources of relative value
differentiation today.

JULY 2024

2

Public fixed income markets tend to offer real-time liquidity

transparency and accessibility. Liquid markets better reflect

to investors. This allows investors to shift from areas where

fundamental asset values and facilitate price discovery.

liquidity premium and risk premium have compressed to

They allow investors to react quickly to new information by

areas that remain attractive – in other words, to pursue

easily trading in and out of assets. That can enhance theactive alpha opportunities instead of applying a buy-and-

opportunity for alpha through active adjustment based onhold approach (learn more in our recent video, “High Quality

incoming information and changes in valuations.

Credit Opportunities”). Additionally, public markets havebecome ripe for alpha given today’s environment of elevatedmacroeconomic volatility, heightened geopolitical risks, andTo be sure, some traditional measures indicate that publicbond market liquidity has diminished. For example, there
has been a reduction in the supply of bonds held by primary

diverging global growth and inflation trajectories.

dealers, which historically have served as market makers.

When investing in private markets, investors give up near-

Recently, we’ve heard arguments – often pointing to theseterm liquidity in an effort to capture a liquidity premium overlower primary dealer inventories – that liquidity in publica longer horizon. Additionally, segments of private markets

corporate credit markets has evaporated, particularly

offer superior documentation through the sponsor-lender

outside of the largest issuers.

relationship, or structural seniority through asset coverage,

However, we believe equating dealer balance sheet size withthat can limit downside risk if credit deteriorates.

public fixed income market liquidity is inaccurate. This is

Based on the significant deal flow we are seeing acrossbecause the primary dealer relationship has become lessmarkets, we also observe that the liquidity premium in many

essential in the wake of technological advances such as

areas of private markets has tightened to unattractive levels –exchange-traded funds (ETFs), all-to-all trading (in which any

as it has in certain areas of public markets. We are also seeing

market participant can trade directly with another without

deterioration in covenants that traditionally protected lenders ingoing through a primary dealer), and portfolio trading.

private credit markets.

For example, portfolio trading allows buying and selling ofInvestors should consider changes in valuations and market

a basket of bonds in a single transaction. It is designed tostructure across private and public fixed income markets inimprove execution and reduce costs. Dealers can hedge

recent years while making allocation decisions.

these trades in the deep and liquid ETF market, where ETF
market makers serve as additional liquidity providers.

GAUGING PUBLIC CREDIT LIQUIDITY

Trade volumes also indicate liquidity is abundant in highLiquidity depends on the number of available buyers

quality public credit markets (see Figure 1).

and sellers, trade size and frequency, and information

Figure 1: Long-term increase in average monthly trade volume in public investment grade credit markets
900

Monthly IG trade volume ($ billions)

800
700
600
500
400
300
200
100
0

2008

2009

2010

Source: TRACE as of 30 April 2024

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

JULY 2024

3

Figure 2: Only a fraction of outstanding public investment grade bonds don’t trade each month
3.0%

Outstanding (% of total)

2.5%

2.0%

1.5%

1.0%

Nov-23Jun-23Jan-23Aug-22Mar-22Oct-21

May-21

Dec-20Jul-20Feb-20

Sep-19Apr-19

Nov-18Jun-18Jan-18Aug-17Mar-17Oct-16May-16

Dec-15

Jul-15

Feb-15

Sep-14Apr-14

Nov-13Jun-130.0%

Jan-130.5%

Source: Barclays as of 1 December 2023

Ongoing innovation in technology and product design should(bps) a year. That includes the cost of lost alpha from active

continue to support liquidity and increase trading volumes inmanagement of fixed income portfolios, the cost of the

public markets, in our view.

inability to rebalance portfolios, and the cost of liquidity

Average daily trading activity for U.S. dollar investment

shortfalls for unexpected liquidity needs.

grade (IG) bonds in 2024 is $34.8 billion as of 25 June,

Meanwhile, the compensation for providing liquidity is

according to J.P. Morgan. As shown in Figure 2, only a small

declining across both public and private credit markets aspercentage of IG bonds don’t trade each month.

more capital chases too few opportunities. New investments
are entering at potentially unattractive valuations, with

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 comesfrom trades arising out of market dispersion or buying
undervalued assets. The cost of providing liquidity is the netpresent 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 theportfolio against this risk.
Based on these risks and associated costs, we estimate
long-term illiquidity costs to be around 200 basis points

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 lessattractive 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 ininvestment grade segments of private credit markets has
tightened to less than 100 bps. We believe that level isinsufficient relative to the opportunity costs associatedwith rebalancing, lost alpha from public fixed income, andpotential costs of cash shortfalls.

JULY 2024

4

Additionally, many private investment grade issuers areobserve something similar. The spread premium for private

also able to access more liquid public fixed income markets

corporate direct lending relative to broadly syndicated loans

and thus are only willing to pay a small additional spreadhas tightened from about 400 bps three years ago to 193

to borrow capital in private markets for certain capitalbps in 2024 (see Figure 3), according to PIMCO calculations

structure nuances that affect credit quality. Adjusting

based on Lincoln and LSTA data.

for credit quality differences between public and private

Weighing the shrinking liquidity premium against theinvestment grade issuers, the excess spread of less thanassociated costs to provide that liquidity suggests that

100 bps becomes even less attractive.

investors today are receiving inadequate compensation

When we shift beyond investment grade and compare thefor locking up capital in certain private credit areas,

broadly syndicated loan market versus private corporate

particularly those where incentives are to raise capital andcredit (middle market direct lending investments), we

deploy funds immediately.

Figure 3: Declining compensation for locking up liquidity in private credit
Lincoln Private Credit Index yield (A)LSTA US Leveraged Loan 100 Index yield (B)Yield differential (A-B)

6 year yield differential average

14%
12%

11.35%

Yield to maturity

10%

9.42%
8%
6%
4%

3.34%
2%

1.93%
Q1 2024

Q4 2023

Q3 2023

Q2 2023

Q1 2023

Q4 2022

Q3 2022

Q2 2022

Q1 2022

Q4 2021

Q3 2021

Q2 2021

Q1 2021

Q4 2020

Q3 2020

Q2 2020

Q1 2020

Q4 2019

Q3 2019

Q2 2019

Q1 2019

Q4 2018

Q3 2018

Q2 2018

Q1 2018

0%

Source: Lincoln International, LSTA as of 31 March 2024. Past performance is not a guarantee or a reliable indicator of future results. It is not possible to invest directlyin an unmanaged index. The Lincoln Private Credit Index tracks the fair market value of 1,600 middle market, direct lending credit investments. The LSTA US Leveraged
Loan 100 Index measures the market-weighted performance of the largest institutional leveraged loans based on market weightings, spreads, and interest payments.

CREDIT QUALITY DIFFERS ACROSS
PUBLIC AND PRIVATE MARKETS“Yield Advantage”). These are typically smaller,

Investors should also take into account the differences inmaking them vulnerable to sustained high interest rates,

leveraged companies financed with floating-rate debt,

average credit quality between public and private credit markets:

economic slowdowns, defaults, and lower recoveries.

•

Credit quality and free cash flow generation: Private

coverage ratios (how well earnings cover concurrent

corporate credit is heavily concentrated in sectors

interest payment expenses) for private companies

such as technology and health services, which aremuch more than in public markets. The percentage ofsusceptible to AI disruption and changing businessprivate corporate direct lending borrowers with fixed

conditions (for more, see our latest Secular Outlook,charge coverage ratios below 1x has risen from 15.9%

Higher interest rates have started to affect interest

JULY 2024

5

two years ago to 40% this year (see Figure 4). This

Market shifts and innovations: Many higher-quality

means 40% of private credit borrowers (size weighted)

companies have been moving back to public markets,

are not producing enough cash flow to service all debt,

leaving private credit portfolios with selection bias

taxes, and capital spending needs. If interest rates

issues. Private credit innovations like synthetic

stay elevated for longer or economic growth slows,

payment-in-kind (PIK) structures – which allow

these borrowers would be more vulnerable to further

interest payments to come from other borrowings

increases in leverage, declining credit quality, and higher– may merely mask borrower stress as higher rates

expected losses. Such a credit cycle would likely createpressure free cash flow in older investments.

attractive opportunities to provide new financing withpreferable terms to new investors.
••

Balancing the risks and costs against potential investment
returns within private markets more broadly, we see

Private equity dynamics: Private equity owners

many attractive options for investors who can manage

are experiencing longer hold periods and valuation

around illiquidity – but careful selection within sectors

pressures due to the sharp rise in base rates, whichand companies is key (learn more in our recent video,

has diminished their willingness and ability to support“Unlocking the Power of Private Credit”).

portfolio companies. Furthermore, the influx of new
entrants into the space has weakened the importanceof the sponsor-lender relationship and led to a
deterioration in private credit documentation.
Figure 4: More private credit borrowers face difficulties covering interest payment expenses
Percentage of private credit borrowers with fixed charge coverage ratios under 1x
45%

40.0%

40%

34.3%

35%

36.2%

31.4%

30%
25%
20%

15.9%

15%

14.0%

21.8%

21.4%

Q4 2022

Q1 2023

15.4%

10%
5%
0%

Q1 2022

Q2 2022

Q3 2022

Q2 2023

Q3 2023

Q4 2023

Q1 2024

Source: Lincoln International as of 31 March 2024. Fixed charge coverage ratio (FCCR) = (LTM EBITDA - Taxes - Capex) / (Interest Expense + (1% * Total Debt)).
Capital expenditures (“Capex”) utilizes LTM Capex by default. If LTM Capex is not available, NFY Capex is utilized, and LFY Capex if both LTM Capex and NFY
Capex are unavailable.

JULY 2024

6

CONCLUSIONPIMCO’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 bepermanently 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 andliquidity spectrum.
With inflation falling toward central banks’ targets, high quality fixed income may also offer an attractive, liquid hedge torisk 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.

Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies
are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bondprices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased
market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Alternatives involve a high degree ofrisk and prospective investors are advised that these strategies are appropriate only for persons of adequate financial means who have no need for liquidity with respect
to their investment and who can bear the economic risk, including the possible complete loss, of their investment. Private credit involves an investment in non-publicallytraded securities which may be subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that
increase the risk of investment loss.
Charts are provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product.
Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer orsolicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record,
do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of
results that a client portfolio may achieve.
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that theseinvestment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term,
especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
This material contains the current opinions of the manager and such opinions are subject to change without notice. This material is distributed for informational
purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained
herein has been obtained from sources believed to be reliable, but not guaranteed.

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