In previous research, we quantified the extent to which private credit is concentrated in senior, floating-rate loans. In this piece, we now turn to the critical question of risk in private credit, using contractual loan spreads as a proxy for credit risk. Using loan data from the MSCI private-credit security-terms dataset, we find a surprising degree of convergence between senior and mezzanine spreads for corporate loans since 2022.[1] In contrast, the gap between spreads of senior and mezzanine loans to the real-estate sector has widened marginally over the same period.
Private-credit GPs have made safer mezzanine corporate loans
While spreads on private-credit senior corporate loans have varied little over the last four years — other than a modest reduction in the dispersion of spreads — private-credit funds began extending mezzanine financing to companies at falling spreads starting in 2022, coinciding with interest rates lifting off from zero. As of the second quarter of 2024, the spreads of senior and mezzanine loans are almost indistinguishable.
This contraction of mezzanine spreads is not attributable to observable characteristics like geography and sector of the borrower, or collateralization and maturity of the loan; along these four dimensions, senior and mezzanine loans are almost perfectly matched in recent quarters. Thus, declining mezzanine spreads relative to senior are not due to mezzanine loans going increasingly to low-risk regions, like the U.S., or disproportionately requiring collateral, for example.
Instead, it is likely that private-credit general partners (GPs) are tightening mezzanine underwriting along other dimensions, and essentially reserving mezzanine financing for only the lowest-risk borrowers, while senior-loan underwriting has remained relatively unchanged. This defensive behavior by mezzanine lenders corresponds to an environment of rising interest rates that could have put undue strain on riskier borrowers.
One feature continues to distinguish the spreads of mezzanine from senior loans, however. There is a persistent right skew in mezzanine spreads, as evinced by the gap between the mean and median spread. While mean and median senior-loan spreads are consistently very close (indicating spreads are approximately symmetrically distributed), mean mezzanine spreads remain higher than medians, driven by a relatively small, but disproportionate number of loans at high spreads. This right tail in mezzanine spreads suggests that more risk remains in the pool of mezzanine loans, but it is concentrated in a fairly small number of loans.[2]
Private-credit loans to real estate buck the trend
Private-credit loans to real-estate borrowers, in contrast, have not experienced the convergence observed in corporates. GPs have consistently judged mezzanine and senior loans to bear quite different degrees of risk, as indicated by the obvious separation between the boxplots in the exhibit below. Spreads on mezzanine real-estate loans have risen marginally in recent years, while senior spreads have not. Given the recent upward drift in mezzanine spreads in real estate and falling spreads in corporate mezzanine loans, private-credit GPs appear to be differentially tightening corporate underwriting while making little change to real-estate lending.
Mezzanine loans to real estate have remained riskier
This differential between corporate and real-estate mezzanine-loan risk likely comes down to collateralization: 71% of private-credit corporate loans — senior or mezzanine — are secured, compared to just 30% of mezzanine real-estate loans and 87% of senior real-estate loans. This disparity has been persistent over the period in question.
As with corporate mezzanine loans, we observe a significant right tail in spreads to real estate, elevating mean spreads well above the median. This holds across both senior and mezzanine loans in real estate — despite low average spreads, there remains a tail of risky loans.
Rethinking risk in private-credit loans
Spreads on corporate mezzanine loans in private-credit funds have fallen dramatically since 2022, likely driven by GPs defensively responding to higher interest rates and selectively tightening underwriting, while those for corporate senior loans have held steady. For investors managing a risk budget, this spread convergence in loans might be reason to refine their private-credit allocations. This convergence is not reflected in private-credit loans to real estate, where senior and mezzanine loans display more disparate risks. Despite this apparent convergence, there remains a more significant right tail of risky mezzanine loans that asset owners should monitor carefully, especially in light of depressed interest-coverage ratios.