Why the next credit cycle rewards the managers with somewhere else to go 

The case for private credit has been made so effectively over the past three years that the asset class now stands in for credit itself in a good many portfolios.

Phil Strano, head of Australian credit research at Yarra Capital Management, thinks that is an error, and that the marketing worked rather too well. 

Australian private credit outstandings sit at around $200 billion, having grown faster over the past two to three years than either bank lending or nominal GDP.

On Strano’s reading, that growth has drawn investors towards a systemic beta exposure concentrated in real estate development debt, and away from the alpha available in liquid credit. It has pulled lending standards along with it, with higher loan-to-value ratios becoming more prevalent as capital chased the sector. 

The concentration 

Private credit represents roughly 10 per cent of system-wide credit outstandings in a market of $2.4 trillion, so a portfolio built around it exposes investors to one segment of one part of the opportunity set.

Strano frames the alternative as a mandate that can target alpha, improve risk-adjusted returns and hold liquidity at the same time, rather than accepting illiquidity as the price for yield.

That mandate is expressed through the Yarra Higher Income Fund, the multi-sector credit strategy Strano manages. 

The Bathla Group collapse has given that argument a live example. The Sydney developer entered voluntary administration in August owing more than $3 billion to around 40 private credit funds, and the effects have run well past the loans themselves.

Centuria Bass froze $670 million of redemptions, and 360 Capital paused trading in its listed securities. Strano expects further defaults among private credit-funded developers as higher interest rates, softer house prices and rising construction costs work through a sector already showing signs of distress. 

“Private credit managers have been extremely successful in marketing the asset class’s virtues of high yields with supposedly low volatility and sufficient underlying security. Perhaps too successfully.”

Flexibility in practice 

A broader mandate also changes what a manager can do with pricing. Residential mortgage-backed securities are one example Strano cites. Mezzanine RMBS spreads widened sharply through the 2022 and 2023 dislocation and have since compressed to levels that leave BBB paper tight against both its own history and relative to AAA spreads. 

Strano’s allocation to RMBS moved with those spreads rather than with a target weight. It peaked at 25 per cent in 2022 and 2023. It rolled down to about 3 per cent today as pricing tightened.

He will rebuild the position only once spreads widen enough to compensate for the underlying risk. That discipline exists only where a manager has somewhere else to deploy that capital in the meantime. A portfolio with a single asset class to allocate to never gets to make that decision. 

That flexibility runs through the portfolio’s construction. Public debt forms the liquid core, letting Strano capitalise on relative value and shift positioning as spreads move.

Syndicated loans and warehouse facilities add higher-yielding exposure within the same risk framework, with private debt capped at 20 per cent so its illiquidity premium does not come at the expense of overall liquidity. There is also no allocation to real estate development finance. 

The income buffer 

Strano puts the strategy’s estimated running yield at 7.3 per cent against spread duration of 3.3 years as at September 2026. On that calculation, credit spreads would need to widen by an improbable 250 basis points over 12 months to generate a negative return.

Under this scenario, a mild recession still leaves an estimated income return of 6.55 per cent. A severe recession with spreads a full percentage point wider leaves 5.80 per cent.

“Alpha isn’t confined to the segment attracting the most headlines. As the credit cycle turns, we believe the advantage will go to managers who can find relative value across the whole opportunity set,” Strano says. 

When reviewing credit allocations before the cycle turns, the useful question is less the yield on offer and more how much of the market a manager is free to move across once that yield stops paying for the risk.