By Andrew Bary

Cracks are starting to form in the $1.5 trillion private-credit market, and the hot sector could face its first major test since exploding in size over the past decade.

Companies like Ares Management, Apollo Global Management, Blue Owl Capital, Blackstone, and KKR are big players in the market. They make high-rate loans at about 10% to smaller junk-grade companies that often have been the target of leveraged buyouts. Private credit has been a critical growth area of the alternative-asset business in the past few years.

Credit losses historically have been low -- and investor returns high -- but that could change if the economy weakens. Most of the funds are private or offer limited liquidity, but the $70 billion of publicly traded business development companies, or BDCs, offer a read on sentiment -- and investors have gotten worried recently.

A sharp selloff has taken shares of BDCs down an average of 20% from their February highs, including Ares Capital $(ARCC)$, Blue Owl Capital $(OBDC)$, Blackstone Secured Lending $(BXSL)$, and FS KKR Capital (FSK). They now yield 10% to 15%.

Julian Klymochko, CEO of the Canadian financial services company Accelerate, notes that the Ares and Blackstone BDCs now change hands around net asset value after trading at steep premiums earlier this year.

Big discounts to NAV have opened up on what investors view as riskier BDCs. FS KKR is at a roughly 20% discount; Blue Owl Capital, 14%; Goldman Sachs BDC $(GSBD)$ and Oaktree Specialty Lending $(OCSL)$, around 23%. These discounts are based on year-end 2024 NAVs.

"BDCs are not a recession-resilient sector due to the illiquid, leveraged nature of private credit. It is too early to gauge the depth of the slowdown, but the possible disruption to business and consumer demand will be a significant concern for investors," wrote KBW analyst Paul Johnson this past week.

One thing to watch is how the BDCs valued their portfolios on March 31, when they report earnings in the coming weeks, given the sharp widening in junk-bond yield spreads this year. That spread widening should theoretically depress portfolio values, but BDCs tend to not mark them down unless the underlying loans encounter credit problems.

Klymochko favors the BDCs trading at big discounts, arguing that their stock prices already discount high default rates.

One danger with BDCs is leverage. Unlike junk-bond mutual funds and ETFs, which tend to use little or no leverage, BDCs generally use a dollar of debt for every dollar of investor equity. This amplifies risk. Given the selloff in junk bonds this year, one could say that BDC NAVs should be down 5% or more.

In evaluating BDCs, investors should look at their portfolio's credit quality, which some managers have built better than others. The safer ones concentrate on senior secured loans, which carry the least amount of risk. Subordinated debt, preferred stock, and equity would suffer more in a downturn.

A good alternative to BDCs are junk-bond closed-end funds like BlackRock Corporate High Yield $(HYT)$. It now trades below $9 a share and yields almost 11%. It has a liquid portfolio of bonds from large companies like Charter Communications, and its holdings are regularly valued based on market prices. It has lower fees and leverage than most BDCs.

Write to Andrew Bary at andrew.bary@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

(END) Dow Jones Newswires

April 12, 2025 15:03 ET (19:03 GMT)

Copyright (c) 2025 Dow Jones & Company, Inc.