Private credit in a yield-compressed environment: opportunity or overextension?

The Australian private credit market has expanded from approximately $18 billion in 2019 to an estimated $64 billion in assets as of late 2025. This growth reflects both genuine structural opportunity in mid-market lending and a concerning drift toward yield compression that risks eroding the returns that justified the asset class's emergence. The question facing allocators is no longer whether private credit should be part of a diversified portfolio—it clearly should—but whether the risk-adjusted returns currently available justify the premium capital deployment that credit allocators are increasingly willing to tolerate.

The structural drivers of private credit growth

Australian private credit has grown for legitimate reasons. Regulatory capital requirements imposed on traditional banks following the 2017 Royal Commission have constrained bank lending to mid-market borrowers, particularly those with non-standard structures or leverage profiles. This created a genuine white space for non-bank lenders. Superannuation funds, facing structural pressure to improve yield in an environment of declining public bond yields, have increased allocations to credit. These allocators have capital, patient time horizons, and tolerance for illiquidity—precisely the characteristics that make them efficient capital providers for direct lending.

The mid-market borrower base has also evolved. Businesses in the $5-100 million EBITDA range increasingly prefer direct relationships with credit providers rather than navigating syndication processes through traditional banks. Non-bank lenders can customize documentation, move faster, and maintain longer-term relationships without the pressure to exit positions that banks face.

The issue with private credit is not its existence. It is that yields have compressed below the level required to compensate for illiquidity, complexity, and the systematic risk that private borrowers will struggle in a recession.

Yield compression: from 8.5% to 6.5% in five years

In 2019-2020, high-quality mid-market direct loans in Australia yielded 8 to 9 per cent. As competition intensified and capital flooded into the asset class, those yields have compressed materially. Today, first-lien, investment-grade credit attracts yields of 5.5 to 6.5 per cent, depending on structure. Subordinated and covenant-lite deals can achieve 7 to 8 per cent, but at materially elevated risk. The spread over government bonds—the core compensation for credit risk—has narrowed from 550-650 basis points to 300-400 basis points for investment-grade tranches.

This compression reflects supply and demand dynamics. Capital allocated to private credit has expanded faster than quality deal flow. Lenders have responded by reaching for yield, taking on weaker sponsors, lighter covenants, and higher leverage. This is the canonical pattern that precedes credit losses.

The covenant-lite epidemic

A particularly concerning trend is the proliferation of covenant-lite structures in Australian direct lending. These deals rely on borrowers' good behaviour and refinancing capacity rather than binding financial covenants or maintenance metrics. In benign markets, covenant-lite debt functions perfectly well. In stress, it becomes a binary bet on whether the borrower survives to refinance. During the 2020 COVID shock, lenders who had moved into covenant-lite territory faced severe pain when obligors couldn't meet scheduled interest payments and lenders had minimal recourse short of enforcement.

Comparison to US and European markets

The U.S. private credit market is substantially more developed, with yields currently in the 5 to 5.5 per cent range for leveraged loans and 6 to 7 per cent for direct lending. The fact that Australian private credit yields a premium to U.S. equivalents reflects both lower absolute yield environments (Australian RBA rates remain above U.S. Fed funds) and the Australian market's relative youth. However, U.S. experience should concern Australian allocators. Yield compression in U.S. credit preceded the 2020 COVID shock and again preceded the 2023-2024 credit stress that followed rate hikes. Allocators who allocated to U.S. credit on the basis of the "extra" yield have faced significant losses. The Australian market is following a comparable arc, but compressed into a shorter timeframe.

European private credit: a cautionary tale

European private credit faced more dramatic compression, with covenant-lite deals dominating the market by 2021-2022. When interest rates rose sharply in 2023, European lenders faced a wave of refinancing pressure from obligors that had relied on continuous access to cheap capital. Losses mounted, and allocators withdrew. The European market has not recovered its pre-loss pricing power, and many allocators remain underexposed to the asset class.

The super fund allocation paradox

Australian superannuation funds have become the marginal buyer of private credit. These allocators face structural pressures: declining yields on public equities and bonds, long-dated liabilities that require yield, and a mandate to match returns to benefit growth rates. Private credit, yielding 6-7 per cent net of fees, appears attractive. However, super funds are also systemically important to Australian financial stability. If losses mount in private credit and super fund allocations suffer unexpectedly, we could see redemption pressure and forced selling—precisely the scenario that generates tail risk in illiquid assets.

Risk management implications

For borrowers in the Australian mid-market, the current private credit environment presents both opportunity and risk. The opportunity is access to capital from lenders who understand your business model and can customize documentation. The risk is taking on leverage at yields that assume benign refinancing conditions. A business that borrows at current private credit yields should stress-test its ability to meet interest payments if rates rise another 2 per cent and refinancing windows narrow materially. Many will find their debt serviceable at current yields but stressed at refinancing.

For allocators, the case for private credit remains sound, but the case for allocating at current yields is increasingly tenuous. Yield compression has moved beyond rational risk compensation. Allocators should calibrate allocations to private credit as a long-term strategic hold, not as a substitute for declining public bond yields. The Australian private credit market will likely experience correction before reaching sustainable equilibrium.