Smooth Returns, Hidden Risks

We view private credit as a potentially valuable component of a diversified portfolio for investors seeking income and long-term capital appreciation. However, it is not a substitute for liquidity, nor is it risk-free. While the asset class can offer attractive income and portfolio diversification benefits, investors need to tread warily given broader risk dynamics and to fully understand said risks vs return prospects.

Recent developments have brought private credit back into focus. Regulatory scrutiny has intensified, early losses are beginning to emerge (particularly in parts of the US market) and concerns are growing around concentration risks, especially within software and technology-related borrowers. With an estimated 20% or more of private credit exposure linked to software firms, questions are being asked about the impact of AI-driven disruption on earnings, cash flows and refinancing capacity.

Against this backdrop, it is worth revisiting the key risks embedded in private credit and, in particular, examining how it compares with another income‑oriented asset class familiar to Australian investors: bank hybrids.

It is important to state upfront what while Mutual Limited’s investment team has extensive experience in private credit, the firm does not invest in private credit within any of its funds or third-party mandates, nor does it intend to do so in the future. The risk profile of private credit does not align with Mutual Limited’s broader investment philosophy, which prioritises liquidity, transparency and capital stability.

Key Risks in Private Credit

1. Limited Liquidity

Private credit investments are typically structured as loans and not traded on public markets.  Accordingly, secondary liquidity is heavily constrained, and investors often must accept their capital is committed for several years. While redemptions are sometimes permitted, they are limited typically to quarterly and only up to a small percentage of fund assets under management (AUM), say 5% - 10%.  Given this absence of tradability, redemptions are often funded from cash flows, which can be further constrained during periods of heightened market stress.

What does this mean for investors? Private credit is best suited for capital that does not need to be accessed in the near term. Investors must be comfortable with the possibility that capital may not be immediately available when markets are under stress.

2. Risk of Borrower Default

Private credit funds lend to companies that may not have access to traditional bank financing, typically firms not formally rated by the rating agencies and therefore considered sub-investment grade with a higher probability of default. These businesses are often smaller or more leveraged and if a borrower experiences financial difficulty, repayment may be delayed or reduced. 

Recent research from UBS suggests private credit default rates could surge to 15%[1] compared with prevailing estimates of 3% - 5% range.  For context, global default rates through the GFC peaked at 15.6% in 2009[2] While not all strategists share this view, the risk of materially higher defaults look to be rising.

What does this mean for investors? While income payments are typically contractual, there is no guarantee they will always be paid. Losses are possible, more so than an investor would expect with investment grade public bonds.

3. Sensitivity to Economic Conditions

Private credit performance depends on the financial health of borrowers.  In stable economic conditions, loans generally perform well. On the other hand, during recessionary conditions, default rates can rise. 

Monetary policy settings also matter. Higher interest rates increase borrowing costs and can strain already leveraged balance sheets, particularly for companies reliant on refinancing.

What does this mean for investors? Even if fund values do not fluctuate daily, economic slowdowns can materially increase risk beneath the surface.

4. Valuation and the Illusion of Stability

Valuation of private credit is amongst the dark arts.  Private credit is not exchange-traded, so valuation is typically model-based, not price-discovery-based. That creates structural differences versus public credit.  At a very high level, value equals the present value of expected future cash flows, discounted at a market implied yield. In theory, private loans are not priced daily on any exchange and any valuation updates are made quarterly. 

What does this mean for investors?  Returns may appear smoother than public bond markets, but underlying risks remains. The bottom line is private credit valuation is model-based, spread-sensitive, impairment-driven, and typically slow-moving until credit stress becomes undeniable.

5. Manager Discipline Matters

Private credit is not a passive asset class. Underwriting standards vary, ongoing due diligence and experience navigating stressed situations is critical.  Some managers may take greater risk in pursuit of higher yields than others.

What does this mean for investors? Manager selection plays a significant role in outcomes. Poor underwriting decisions can have long‑lasting consequences in illiquid portfolios.

6. Fees and Expenses

Private credit has an array of fees and expenses to be mindful of. They include management fees (~1.00% - 1.25%), operating expenses (~0.30% - 0.60%), performance fees (~0.50% - 2.00% or more), and potentially foreign currency hedging costs (~0.30% - 1.00%) where offshore exposure exists. Add this up and the estimated total cost drag of ~2.00% - 4.00% per annum.

What does this mean for investors? Higher fees reduce net returns and must be carefully weighed against expected income. By comparison, public credit funds including Mutual’s own, typically have fee ranges in the 0.5% - 1.0% range.

Private Credit vs Bank Hybrids: Not a like-for-like switch

Ultimately, the greatest risk in private credit is not day-to-day volatility, but a sudden collapse in confidence.  Illiquid, model-valued assets with periodic redemption features can expose the gap between perceived stability and underlying credit risk when sentiment turns.  Defaults may rise, refinancing conditions tighten, or investors rush to redeem at the same time – I call this the George Costanza trade, “women and children first, get out of my way.” Consequently, funds may impose gates, delay withdrawals or reprice assets sharply.

For retail investors, this means returns that appeared smooth can change quickly — and access to capital may not be immediate, when it is most needed. Private credit can play a role in diversified portfolios, but it should be approached with realistic expectations about liquidity, valuation transparency and the true downside risks in a stressed environment.

Anecdotally, many retail investors have been drawn to private credit as a replacement for their bank hybrids, particularly as APRA phases bank hybrids out as an acceptable form of capital, with an end date of2032.  The challenge here is that this is not a like-for-like transition.  There is an illusion of symmetry between the two asset classes. Both are floating‑rate, offer higher yields than term deposits and are marketed to income‑focused investors. Beyond that, the similarities fade.

Bank hybrids are exposed to systemic banking stress and are sensitive to equity volatility but they are priced daily and traded on the ASX.  Private credit on the other hand is exposed to SME leverage and refinancing cycles. It’s sensitive to credit spreads and default clustering, while valuations adjust slowly, if at all.

What are the alternatives?

For investors seeking income with greater transparency and liquidity, there is a broad range of income‑generating funds underpinned by public credit markets. These securities are traded, priced daily and offer materially superior liquidity dynamics, while delivering return profiles comparable to bank hybrids.

Mutual Limited offers two such strategies—the Mutual Credit Fund and the Mutual High Yield Fund—which may be considered hybrid alternatives for investors prioritising liquidity, transparency and capital stability.

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[1] UBS Investment Bank Credit Strategy note (Sachin Ganesh et al.), February 2026; as reported by Bloomberg.

[2] Standard & Poor.