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(Bloomberg) — Current private debt returns fail to justify the growing risk, according to Pacific Investment Management Co. 

“Fundamentals are deteriorating in more levered portions of the credit markets,” said Mohit Mittal, chief investment officer for core strategies at Pimco. “You’re seeing more complacency, so you have to be very thoughtful — you have to be very careful.”

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Private credit has more than doubled in size since 2019, ballooning into a $1.7 trillion industry. At the same time, returns in publicly-syndicated corporate debt markets have become significantly compressed compared to those available from direct lending, according to the investment management firm which oversees about $1.9 trillion in assets.  

“There needs to be compensation well north of 200 basis points in going from public credit into private credit, and we don’t see that in the current market,” Pimco’s Mittal said in the latest Bloomberg Intelligence Credit Edge podcast, referring to high-yield debt. 

Click here to listen to the full interview with Pimco’s Mohit Mittal

The current excess premium for less-liquid levered investments is about 190 basis points on average. In investment grade credit, private markets pay about a 50 basis points spread over public, half the 100 basis points return they should offer, according to Mittal.

The yield pickup to publicly traded corporate bonds and loans is intended to compensate investors for the relative lack of liquidity and credit-quality differences in private debt. It should also cover the risks of being locked up in an investment for the long term, and any excess return that could’ve been made in public markets, Mittal said. 

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“The opportunity cost of going from public fixed income into private has gone up as yields have moved higher in the last two or three years,” said Mittal. “That’s one of the reasons for our strong preference for high-quality public fixed income relative to private,” he added. 

While Mittal concedes that spread differentials between public and private markets could tighten further, he sees stresses building up in private markets — such as companies struggling to keep up with debt payments — slowing deployment of capital. He also notes weaker lender protections on direct loans.

“What you observe is that 40% of the companies now have that fixed-charge coverage ratio of less than one, meaning they’re not producing enough cash flow to cover the interest expense,” said Mittal. 

Despite the pessimism, Pimco still likes private markets, though it prefers asset-based finance. Within that, the Newport Beach, California-based money manager sees value in the consumer sector — including housing — as well as aviation finance, equipment rental and data centers, where there is good asset coverage and strong documentation. 

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“Over the next three, five years we would see asset-based lending play out very differently relative to private corporate credit,” said Mittal.

By country, Pimco sees value in the US, as well as in the UK, Australia and Canada. By sector, Mittal likes financials, utilities, consumer staples and telecommunications, as well as technology and health care in leveraged finance. He is cautious on debt in the retail and auto sectors.

Mittal said that the single best credit opportunity for the next 12 months is higher-quality agency mortgages, which Pimco expects to perform well even if growth slows and inflation revives. “It’s a spread product that would do well across a range of scenarios,” said the CIO. 

On the podcast, Mittal also discussed:

• The spread of creditor-on-creditor violence as borrowers take advantage of weak covenants to impose losses on investors.
• The potential for the Federal Reserve to cut rates to 3% or lower if there is a recession.
• Fixed income as a diversifier to equity risk, offering more upside, even as stocks drop.
• Opportunities in net-asset-value lending.
• Liquidity enhancements in public debt markets from exchange-traded funds and portfolio trading.

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