Credit‐oriented fixed income instruments like US middle market direct loans achieve their long‐term returns by capturing high yields without offsetting principal impairments by way of realized losses. Chapter 1 stated an 11.15% income return (yield) for US middle market direct loans and a −1.05% annual realized loss since the start of the Cliffwater Direct Lending Index (CDLI) in September 2004. Chapter 4 showed that levels of direct lending income (yield) were consistently and significantly above yields on more familiar and more liquid high‐yield bonds and leveraged loans, even when differences in fees are accounted for. An important question in this comparison is whether there is a difference in credit losses between the −1.05% found for US middle market loans and credit losses for high‐yield bonds and leveraged loans. In other words, is the roughly 3.5–4.5% after‐fee yield spread partially compensating direct loan investors for higher credit losses?
Exhibit 5.1 reports calendar year default, recovery, and loss statistics for high‐yield bonds, leveraged loans, the CDLI, and US bank commercial and industrial (C&I) loans from 2005 through 2017.
EXHIBIT 5.1 Credit losses from high‐yield bonds, bank loans, and middle market loans, 2005–2017.
| High‐Yield Bondsa | Bank Loansa | CDLI Middle Market Debtb | US Bank Commercial and Industrial Loansc | |||||
| Default ratio (%) | Recovery rate (%) | Credit loss (%) | Default ratio (%) | Recovery rate (%) | Credit loss (%) | Credit loss (%)b | Charge‐off rate (%) | |
| 2005 | 2.8 | 56 | 1.2 | 3.0 | 84 | 0.48 | −0.89 | 0.67 |
| 2006 | 0.9 | 55 | 0.4 | 0.5 | 84 | 0.08 | −0.63 | 0.63 |
| 2007 | 0.4 | 55 | 0.2 | 0.2 | 69 | 0.06 | −1.74 | 0.65 |
| 2008 | 2.3 | 27 | 1.7 | 3.7 | 58 | 1.55 | 0.59 | 0.71 |
| 2009 | 10.3 | 36 | 6.6 | 12.8 | 61 | 4.99 | 6.91 | 0.86 |
| 2010 | 0.8 | 41 | 0.5 | 1.8 | 71 | 0.52 | 2.96 | 0.98 |
| 2011 | 1.7 | 49 | 0.9 | 0.4 | 67 | 0.13 | 1.78 | 1.01 |
| 2012 | 1.3 | 53 | 0.6 | 1.4 | 55 | 0.63 | 0.60 | 1.01 |
| 2013 | 0.7 | 53 | 0.3 | 1.7 | 69 | 0.53 | 0.19 | 0.98 |
| 2014 | 2.9 | 48 | 1.5 | 4.3 | 73 | 1.16 | −0.01 | 0.89 |
| 2015 | 1.8 | 25 | 1.4 | 1.7 | 48 | 0.88 | 0.70 | 0.77 |
| 2016 | 3.6 | 31 | 2.5 | 1.5 | 63 | 0.56 | 1.41 | 0.70 |
| 2017 | 1.3 | 49 | 0.6 | 1.8 | 62 | 0.70 | 1.75 | 0.68 |
| 2005–2017 | 2.4 | 44 | 1.40 | 2.7 | 66.5 | 0.94 | 1.03 | 0.81 |
aJPMorgan Markets.
bCliffwater Direct Lending Index (Realized Credit Losses).
cFederal Reserve.
Credit loss equals the product of default ratio and one minus the recovery rate. Data on default and recovery rates are readily available on publicly traded securities from bankers and rating agencies. But because direct loans are privately negotiated and held to maturity there is no database that tracks these statistics. However, realized credit loss rates are available through public filings and those statistics are used to calculate CDLI realized losses, which largely represent credit losses. US bank credit losses on their commercial loans are also provided as a comparison and, like the CDLI, are not disaggregated into default and recovery rates.
Exhibit 5.1 shows that the cumulative average of 1.03% in credit losses from US middle market direct loans over the 2005–2017 period are very close to the 0.94% credit loss ratio for leveraged bank loans and below the 1.40% credit loss ratio for high‐yield bonds. On its face, these comparative loss rates are not surprising. Direct loans have much more in common with leveraged bank loans than high‐yield bonds. Direct loans and leveraged bank loans are primarily floating‐rate, intermediate‐term, senior secured bank loans. High‐yield bonds are fixed‐rate, long‐term, subordinated debt, which an investor would expect to experience higher credit losses, primarily through lower recovery rates. That characteristic is also visible from the data in Exhibit 5.1.
Also shown are charge‐offs on C&I loans made by commercial banks. These losses follow a similar pattern over time with syndicated bank loans and direct loans, but their average loss ratio is slightly lower, equal to 0.81%. These lower C&I losses may be attributable to stricter underwriting standards within US commercial banks. Nonetheless, credit losses across all categories of loans are similar in the aggregate, ranging within 60 basis points over long time periods.