The Eroding Safe Haven

U.S. Treasuries, long deemed the world's safest asset, have begun behaving like risky or even distressed assets. Recent Treasury sell-offs have seen 10-year yields spike above 4.5% amid market turmoil, and in 2022, Treasuries suffered their worst year since 1788, shattering the "risk-free" myth that had guided investment decisions for decades.

The traditional relationship between risk assets and Treasuries has broken down. Instead of seeking refuge in Treasuries during equity volatility, investors have been "looking elsewhere" for stability and yield. This fundamental shift in market behavior represents a paradigm change that has profound implications for portfolio construction and risk management.

Treasury market transformation has been dramatic and unprecedented. Historic losses in 2022, with Treasuries posting their worst annual performance since 1788, have fundamentally altered investor perceptions of government debt as a safe haven. Yield volatility has increased significantly, with 10-year yields spiking above 4.5% during periods of market turmoil.

Investors now require greater compensation for government debt, reflecting a fundamental reassessment of the risk-return profile of Treasury securities. The behavioral shift in how investors view and use Treasuries has created opportunities in alternative fixed income markets, particularly private credit.

The breakdown of traditional safe-haven characteristics has forced sophisticated investors to reconsider their approach to fixed income allocation. The correlation between Treasuries and risk assets has become less predictable, reducing the effectiveness of Treasuries as portfolio hedges and driving demand for alternative sources of yield and stability.

Drivers of the Trust Decline

Several macro forces are undermining bond confidence and reshaping investor behavior. These factors have created a perfect storm where the traditional safe haven no longer provides the expected protection or returns.

Persistent inflation above target levels has been a primary driver of Treasury market weakness. When inflation exceeds the yield on Treasury securities, investors experience negative real returns, making government debt an unattractive investment option. This dynamic has been particularly pronounced in recent years, with inflation consistently above the Federal Reserve's 2% target.

The aggressive Federal Reserve tightening cycle has created additional pressure on Treasury prices. As the Fed has raised interest rates to combat inflation, existing Treasury bonds with lower coupon rates have declined in value, creating significant losses for bondholders. This interest rate risk has made Treasuries more volatile and less predictable than in previous decades.

Soaring government debt issuance has raised concerns about the sustainability of fiscal policy and the ability of the government to service its obligations. The rapid increase in government debt levels has led some investors to question the creditworthiness of the United States, despite its status as the world's largest economy.

Geopolitical tensions and fiscal uncertainty have further eroded confidence in government debt. International conflicts, trade disputes, and domestic political polarization have created an environment of uncertainty that makes traditional safe havens less attractive to investors seeking stability and predictable returns.

Negative real yields in recent periods have been particularly damaging to Treasury appeal. When inflation exceeds nominal yields, investors lose purchasing power by holding government debt, creating a strong incentive to seek alternative investments that can provide positive real returns.

These factors have created a fundamental reassessment of the role of Treasuries in investment portfolios. Investors are increasingly questioning the assumptions that made government debt the cornerstone of conservative portfolios, driving demand for alternative fixed income solutions.

Yield Hunt in Private Markets

The vacuum left by declining Treasury confidence is being filled by private credit and direct lending. The yield premium available in private markets is compelling: U.S. direct lending funds returned over 11% in the year through Q3 2023, versus low single-digit returns for public bonds.

This continues a decade-long trend of approximately 9% annualized returns for private credit – roughly twice the returns of tradable corporate loans. Importantly, private credit loans are often floating-rate, insulating investors from the long-duration risk that punished Treasury holders during periods of rising interest rates.

The yield advantage of private credit has become increasingly attractive as Treasury yields have remained low relative to inflation. Private credit investments typically offer yields of 8-12%, significantly higher than the 1-3% available on government debt. This yield premium compensates investors for the additional complexity and illiquidity of private credit investments.

Floating-rate structures provide additional protection against interest rate risk. Unlike fixed-rate Treasuries, which decline in value when interest rates rise, floating-rate private credit loans adjust their coupon payments based on prevailing interest rates, providing protection against rate increases.

The illiquidity premium available in private credit markets represents another source of return enhancement. Private credit investments are typically illiquid, requiring investors to commit capital for extended periods. This illiquidity is compensated through higher yields, creating an attractive risk-return profile for investors with longer time horizons.

Direct lending opportunities provide investors with access to credit markets that are not available through traditional bond investments. Private credit funds often lend to middle-market companies that are too small to access public debt markets, creating opportunities for yield enhancement through credit risk premiums.

The growth of private credit has been supported by structural changes in the banking industry. Traditional banks have reduced their lending to certain market segments due to regulatory constraints and risk management considerations, creating opportunities for private credit providers to fill the gap.

Growth of Private Credit

The private credit industry has experienced rapid expansion, now reaching approximately $1.6–$1.7 trillion and forecasted to grow to approximately $3.5 trillion by 2028. Banks' retreat from lending and higher yields have "kick-started" this growth.

Many institutional and family office investors are reallocating from low-yield bonds into private debt funds, attracted by higher yields without commensurate volatility. This represents a fundamental shift in how sophisticated investors approach fixed income allocation.

The growth of private credit has been driven by several factors. First, the search for yield in a low-interest-rate environment has pushed investors toward alternative fixed income solutions. Second, the diversification benefits of private credit have become more apparent as traditional fixed income markets have become more correlated.

Institutional adoption of private credit has accelerated as large investors have recognized the benefits of including private credit in their portfolios. Pension funds, insurance companies, and endowments have increased their allocations to private credit, providing a stable source of capital for the industry.

The development of private credit infrastructure has also supported growth. The emergence of specialized private credit managers, improved due diligence processes, and better risk management tools have made private credit more accessible to a broader range of investors.

Regulatory changes have also played a role in the growth of private credit. Banking regulations that have constrained traditional lending have created opportunities for private credit providers to fill market gaps. This regulatory environment has been particularly favorable for private credit growth in the post-financial crisis period.

The forecasted growth to $3.5 trillion by 2028 reflects continued strong demand for private credit solutions. As investors continue to seek yield and diversification, private credit is expected to capture an increasing share of the fixed income market.

Investment Implications

The shift from Treasuries to private credit has profound implications for portfolio construction and risk management. Investors must carefully consider how to incorporate private credit into their portfolios while maintaining appropriate risk controls.

Portfolio allocation to private credit should be based on individual risk tolerance, time horizon, and liquidity needs. Private credit investments typically require longer holding periods and may be less liquid than traditional fixed income investments. Investors should ensure that their private credit allocations align with their overall investment objectives.

Due diligence is critical when investing in private credit. Unlike Treasury securities, which are backed by the full faith and credit of the U.S. government, private credit investments carry credit risk that must be carefully evaluated. Investors should assess the credit quality of borrowers, the structure of loans, and the expertise of private credit managers.

Diversification within private credit is important for risk management. Private credit encompasses various strategies, including direct lending, mezzanine financing, and distressed debt. Investors should consider diversifying across different private credit strategies to reduce concentration risk.

The illiquidity of private credit investments requires careful planning. Investors should ensure that they have sufficient liquid assets to meet short-term needs before committing capital to private credit. The illiquidity premium available in private credit should be viewed as compensation for reduced flexibility.

Professional management is often essential for private credit investing. The complexity of private credit markets and the need for specialized expertise make professional management attractive for most investors. Private credit funds provide access to experienced managers and diversified portfolios of private credit investments.

The transition from Treasuries to private credit represents a fundamental shift in fixed income investing. While this shift offers opportunities for enhanced returns and portfolio diversification, it also requires careful consideration of the additional risks and complexities associated with private credit investments.