Institutional investors’ private debt allocations are ticking up at a time when public fixed-income returns are at a 20-year high, and higher interest rates and economic risks threaten borrowers.

Many investors are accepting illiquidity and other risks in exchange for the diversification, income and, potentially, greater long-term returns than they expect from public fixed income.

With long lockups, investors are betting that an economic downturn won’t cause borrowers to go bankrupt and that interest rates will fall, easing the stress of higher rates on borrowers’ cash flows and their ability to make loan payments.

Their interest in the asset class comes even as public fixed income has made a comeback.

As of May 10, the Bloomberg U.S. High Yield index was up 4.3%, compared with -11.2% in 2022 and the Bloomberg Aggregate Bond index gained 3.5%, up from -13% in 2022.

Over the last few years, investors’ private debt allocations have been ticking up. U.S. public pension plans representing a combined $3.2 trillion in assets have increased their private debt allocations to an asset-weighted average of 3.6% in 2022, up from 2.1% five years earlier, according to data from private markets consultant and manager Cliffwater LLC.

According to Pensions & Investments annual survey of the top 200 retirement plans, private credit assets grew 12.5% to $98 billion in the year ended Sept. 30, despite some asset owners’ portfolios falling during the period.

“From our point of view, private credit is a very good complement to public credit,” said Stephen L. Nesbitt, Cliffwater’s New York-based CEO.

Unlike investment-grade and high-yield bonds, there is less interest-rate risk because senior private credit is floating rate and produces higher yield, Mr. Nesbitt said.

One risk, however, is when companies have to refinance their current debt at higher rates, which would put additional pressure on companies, he said. Mitigating these concerns are that the market expects interest rates to fall, and the economy and revenues are still growing, Mr. Nesbitt said.

So far this year, the $307.2 billion California State Teachers’ Retirement System, West Sacramento; $10.7 billion Chicago Public School Teachers’ Pension & Retirement Fund; and $10.5 billion San Diego City Employees’ Retirement System added or increased private debt allocations.

At its May 4 meeting, the investment committee of CalSTRS reduced public equity by 4 percentage points to 38%, while increasing its private capital allocations, mostly boosting private credit. The committee increased fixed income by 2 percentage points to 14% to fund CalSTRS’ private credit direct-lending strategy. CalSTRS added a 5% private credit allocation to its fixed-income portfolio in 2021.

It’s hard to predict the next tail event — a low-probability event— and so “we have to maintain a diverse portfolio,” said Scott Chan, CalSTRS deputy chief investment officer, at the pension plan’s May investment committee meeting.

Mr. Chan added that tail-risk events such as the recent banking crisis could lead to more investment opportunities for private credit managers because they have more flexibility to take advantage of these occurrences.

Many investors are increasing private credit to take advantage of higher yields, Cliffwater’s Mr. Nesbitt said. Today, direct loans can get yield more than 12%, well above high-yield and investment-grade bonds, which are in the single digits, he said.

Private credit managers’ combined assets under management has taken off. Preqin reports private debt’s total global AUM reached a record $1.5 trillion in September 2022, up from $626.2 billion five years earlier.

What’s also propelling the recent growth of the private credit asset class is the rise in interest rates because the majority of loans are made with a floating rate, allowing the lender to charge more and boost profits when interest rates go up, said Karin Anderson, Chicago-based director, North America credit manager research at Willis Towers Watson PLC.

What’s more, the recent banking crisis is expected to expand private debt managers’ investment opportunity set.

“The banking crisis with medium and small banks pulling back from lending is a great opportunity for private debt,” Ms. Anderson said. “Private debt will be able to step in and do more lending presumably.”

The big drawback for investors is the illiquidity, Ms. Anderson said.

“The reason people have trouble moving ahead is your money will be locked up for a while,” Ms. Anderson said.

Core middle-market direct lending is locked up seven to eight years, including a three-to-four year period for managers to invest the capital, she said. Other types of private debt, such as real estate and infrastructure, have even longer periods of 10 years or more, Ms. Anderson said.

“Some investors can’t get comfortable with that period of time,” she added.

A bigger macro risk for borrowers is that interest rates will remain elevated, which could crimp their ability to pay back the loan on their floating-rate debt, Ms. Anderson said. If there is a prolonged, deeper recession, private credit lenders may have to renegotiate loan terms, she added.

Even so, returns for some private credit investments should outperform the public markets, Ms. Anderson said.

“It’s fair to estimate” that the most conservative private-credit sector, middle-market senior credit, will still produce a 10% return, outperforming the high-yield and investment-grade bonds, she said. From a risk tolerance standpoint, many investors are looking for standard, plain vanilla private credit, Ms. Anderson said.

In the 10 years ended June 30, 2022, private debt produced an average total return of 7.8% compared with 2.4% for all fixed income, Cliffwater data shows.

Potential yield and return

Investors without a private credit allocation should consider adding it for the potential yield and return, Ms. Anderson said.

At the same time, investors with private credit portfolios are evaluating whether “they are still comfortable” with size of their private debt allocations, given the yields currently in the public fixed-income markets, Ms. Anderson said. Many investors had boosted or added private debt in the last several years at the expense of investment-grade corporate bonds, she said.

Private credit managers say that private credit offers a number of advantages over public fixed income.

In private credit, there is “more leeway to invest in the best opportunities, independent of benchmarks” than public fixed income, said Chris Wright, Los Angeles-based managing director and the head of private markets at $41 billion credit and fixed-income manager Crescent Capital Group LP.

“There’s now a significant amount of capital for private debt through BDCs (business development companies), private structures … and that significant amount of capital has allowed us to increase the aperture of the size of the companies we can go after,” Mr. Wright said.

So far, Crescent Capital executives are not seeing “a compression of return” and are getting premiums from larger companies, Mr. Wright said.

“We’re seeing investments in senior debt at 12% to 13% yields,” he added.

But higher interest rates are having an impact; some borrowers are starting to ask lenders for amendments to loan agreements and work-out arrangements for their loans, industry insiders said.

“The volume of amendments, work-outs and defaults have picked up a bit,” said Andrew Schardt, Conshohocken, Pa.-based head of investment strategy, co-head of investments and co-head of direct credit at Hamilton Lane Inc., which has $57.2 billion in private credit assets under management and supervision as of Dec. 31.

But the industry has learned lessons from the global financial crisis with lower loan-to-value percentages and flexible capital structures that allow for work-outs and amendments, he said.

“Amendments are nothing new,” Mr. Schardt said. “We would expect to see an increase in amendments, particularly deals done in peak pricing and peak leverage.”

That’s not necessarily bad for lenders because they typically get amendment fees and enhanced interest rates, Mr. Schardt said.

For investors, debt fund managers would likely need to use a fund extension period typically provided in the fund documents, he said.

Loans amended, extended

Bill Ammons, founding partner and portfolio manager at AlbaCore Capital Group, said he has not seen many loan defaults, but also is noticing an increase in “amend and extend,” meaning loans that are amended and whose periods are extended. AlbaCore manages $9.5 billion in AUM in private and liquid credit strategies.

However, to receive an extension, AlbaCore generally requires the borrower to pay down 20% of the loan to derisk it, he said.

Money managers “with disciplined underwriting and strong investment judgment are highly cognizant of the risks,” said Bruce Richards, New York-based chairman and chief executive officer of private credit manager Marathon Asset Management LP, which has $20 billion in assets under management.

These risks include a recession leading to higher default rates, higher debt-service costs for borrowers, companies with overleveraged balance sheets, and loan documents with few covenants protecting the lender, all of which could result in lower recovery rates for lenders and companies in structural decline, Mr. Richards said.

For investors, many of which are fully allocated to public and private equity, “private credit distributes contractual cash (flows) that are now 500 basis points greater than what was paid over the last decade, a compelling value proposition,” Mr. Richards said.