If one monitors financial markets for long enough, they will likely start to see certain patterns of behavior emerge over the decades. The story goes like this: An investment bank or fund manager markets an investment that has the potential to offer higher returns in seemingly similar investments. The “seemingly similar” moniker is important because often the difference between the investments is important as it includes a risk that is the reason the investment offers potentially higher expected rates of returns.
As long as the risk does not surface, the higher interest rates will appear like free excess return. But then the risks never seem to remain hidden for too long and eventually surprises investors, leading to a destabilizing exodus from that segment of the market. Those who do not get out quickly enough end up baring the full burden of the losses while the excess return produced during the good times were spread more broadly across many investors.
One of these common risks is liquidity. Liquidity is the ability to sell an investment quickly without incurring high transaction costs or causing prices to fall. An example of a highly liquid investment would be a checking account which can be accessed any time at very low cost, and no risk of the account value declining because of the withdrawal. An illiquid investment example is real estate which cannot be sold quickly, often requires high transaction costs, and if too many people in an area all seek to sell at the same time it can cause market prices to dip.
The problem with liquidity is that it only becomes an issue when many people want to sell. When an investment is being hyped the liquidly may appear high because there is money flowing into the market segment. Too many investors entering a small market that does not have the infrastructure to support an orderly withdraw is a recipe for trouble.
This is how the private credit market has come to make headlines in recent weeks. It is not that private credit in and of itself is a bad investment or highly risky under normal circumstances. In fact, private credit can be a source of high returns for investors that are in a position to accept the risk of low liquidity. For example, long-term investment programs like those implemented by insurance companies or pensions can be a good fit for private credit because they can afford to have a percentage of their portfolio tied up in illiquid investments in exchange for a slightly higher interest rate.
The problem occurs when these types of illiquid investments are marketed to investors who have relatively high liquidity requirements. Once there is some uncertainty about the investment’s prospects these investors are prone to all run for the door at the same time causing outflows to far exceed inflows which may cause prices to fall. This is different than the behavior of long-term investors which often will ride out short-term volatility choosing to focus on future values rather than current prices.
Private credit has been marketed to individual investors as a way to earn higher interest rates with little additional risks. With the focus on higher returns and little attention paid to the increased risks, the market grew significantly, but its resilience did not. In fact, as investment managers worked to deploy all of the new money that was coming into the market they were forced to invest in more marginal borrowers. A recent default by one of these borrowers triggered a run on the market and shorter-term investors scrambled to get out before the liquidity dried up. This caused prices to fall. In response many of the largest investment companies specializing in private credit suspended redemptions. This means investors cannot get their money out at any price as the investment managers try to stop the selling pressure in the market. Basically, the liquidity went away, which could be a big problem for investors who need access to their funds for short-term needs.