How to Use Private Debt in Your Portfolio

In this series on portfolio basics, I’ll explain some of the fundamentals of putting together sound portfolios. I’ll start with some of the most widely used types of investments and walk through what you need to know to use them effectively in a portfolio.

What Is Private Debt?

Private debt is a broad category that includes any type of loan, bond, or other obligation held by private companies. While “private credit” is often thought of as the same thing, private credit is a specific type of private debt that refers to loans and debt financing provided by nonbank lenders, such as asset-management firms. Direct lending, in turn, is a subset of private credit that focuses on senior loans made to midmarket companies without an intermediary.

Other investment strategies that fall under the private-debt umbrella include distressed debt (which is rated below-investment-grade and/or consists of obligations that the borrower has stopped making payments on) and mezzanine debt (which is ranked lower in the capital structure and has some equitylike features, such as warrants or convertibility).

Like private equity, private debt has become increasingly popular in recent years. PitchBook estimates that private-debt assets under management expanded from $557 billion in 2014 to more than $2 trillion in 2023. What’s the appeal? In a period when interest rates were generally trending down, private debt has often offered investors significantly higher yields. As my colleague Jason Kephart recently pointed out, private-debt funds have offered distribution rates of 10% or more, compared with about 6% for high-yield bond funds focusing on publicly traded debt.

Another reason behind the growing interest in private debt: There’s simply more of it available. In the wake of the global financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act tightened rules on capital and liquidity for banks, which made it tougher for them to make loans to small and medium-size companies. With fewer bank loans available, private-credit firms have stepped in to fill the void.

What Are the Advantages and Risks of Investing in Private Debt?

As the graph below illustrates, private debt has generated impressive returns over the period since mid-2008. All of the major private-debt benchmarks have generated returns well above those of publicly traded bonds over that period. The PitchBook Private Debt All US Index has compounded returns by about 8.6%—surpassing the Morningstar US Core Bond Index of publicly traded bonds by more than 5 percentage points per year.

As with private equity, these impressive performance numbers require a couple of asterisks. Private-debt funds typically report returns using an internal-rate-of-return calculation that incorporates the beginning and ending values of the fund, as well as interim cash flows. One drawback to this method is that it assumes investors can reinvest any interim cash flows at the same rate of return, which is usually not the case. And in contrast to total-return calculations that comply with global investment performance standards, internal rate of return does not have a single standard calculation method and can also be subject to manipulation by “gaming” the timing of cash flows.

In addition, reported IRR figures are subject to reporting lags because of the manual process of determining valuations on private debt, making it difficult to compare private-market assets and other parts of a portfolio in a timely fashion.

Like private equity, private-debt funds also have a wide dispersion of returns, meaning that investors’ actual results depend heavily on the performance of specific funds. PitchBook estimates an annualized return spread of about 9 percentage points between the top and bottom performance deciles of private-debt funds with vintage dates of 2019, for example. The dispersion of returns can be even wider for riskier fund types, such as distressed debt.

In addition, higher returns generally come with elevated risk, and private debt is no exception. As shown in the scatterplot below, the main private-debt subasset classes have all been more volatile than publicly traded investment-grade bonds.

Private debt has been subject to a greater degree of drawdown risk. Direct lending suffered a particularly bad stretch during the global financial crisis, when it shed about 44% of its value. Distressed debt experienced a drawdown of about 33% around the same time. Moreover, the actual level of risk for private debt is probably understated, given the performance measurement issues discussed above.

How to Invest in Private Debt

There are several ways to invest in private debt. To gain access directly, investors must meet “accredited investor” requirements, which generally require annual income of at least $200,000 (or $300,000 joint income) for the two previous years as well as the expectation that income will reach the same level in the current year. Investors can also be considered accredited investors if they have a net worth (either individually or with a spouse) of at least $1 million or have certain roles with the company issuing unregistered securities. Some private-debt vehicles may require investors to meet “qualified investor” requirements, which require investment assets of at least $5 million.

Other Investment Options

However, individuals at lower wealth levels now have other options for private-debt exposure, including investing in a closed-end fund or exchange-traded offering. The table below shows some of the options available with relatively low investment minimums.

In general, investors can’t simply buy an exchange-traded fund focusing on private debt because ETFs and mutual funds aren’t permitted to invest more than 15% of their assets in illiquid securities. However, a couple of ETFs have worked around this limitation by investing in private collateralized loan obligations, which are structured financial products backed by pools of leveraged bank loans. The recently launched SPDR SSGA IG Public & Private Credit ETF PRIV, meanwhile, skirts liquidity requirements thanks to an arrangement with Apollo, an asset-management firm that has agreed to buy back a portion of the fund’s holdings (up to 25% in a day and 50% in a week) if the fund needs to sell off holdings to meet redemptions.

Most of the other investment options are closed-end funds that are structured as interval funds or tender-offer funds. Interval funds typically allow investors to redeem 5% to 25% of their shares every quarter (with the specific amount specified by the board each quarter), while tender-offer funds may only allow periodic redemptions of up to 5% of an investor’s account. This lack of liquidity is one of the major negatives for many of the funds that are currently available to smaller investors.

Another major drawback: high expenses. As shown in the table, expense ratios for these funds are significantly higher than those of funds and ETFs that focus on public markets. That gives private-debt funds a much bigger hurdle to overcome in generating returns.

How Long Should I Hold My Investments in Private Debt?

Based on Morningstar’s Role in Portfolio framework, I recommend holding any investments in private debt for at least six to 10 years. This guideline is partly based on looking at the historical frequency of losses over various rolling time periods ranging from one year to 10 years. Another consideration is the maximum time to recovery, or how long it usually takes to recover after a drawdown.

How Much of My Portfolio Should Be in Private Debt?

Looking at the market value of private debt relative to public fixed-income assets is a reasonable starting point for answering this question. Based on data from Ocorian, private-debt assets totaled about $1.2 trillion as of the end of 2024, compared with about $117 trillion for publicly traded debt. That would suggest a relatively tiny allocation of about 1% of fixed-income assets. However, it’s worth noting that because of its higher level of credit risk, private debt courts some of the same dangers as stocks—namely, poor performance during economic downturns. This potential risk, along with high costs and limited liquidity, is another reason to be skeptical about the hype surrounding private-debt instruments.