The Hidden Risk Behind High-Yield Private Credit Funds

A fund paying an 11 per cent yield can look attractive.

For a saver, a retiree, or anyone trying to make their money work harder, it sounds simple: put money into an income fund, receive regular cash payments, and enjoy a much better return than a bank account.

But in finance, a high yield is never just a gift. It is usually a price tag for risk.

One area where this matters today is private credit. Private credit has become one of the fastest-growing parts of modern finance. It helps companies borrow money outside the traditional banking system. It can also give investors higher income than ordinary bonds. But the same features that make private credit attractive can also hide stress until quite late.

The important question is not simply:

“How much income does this fund pay?”

The better question is:

“Where does the income actually come from, and is the borrower really paying it in cash?”

That second question is where the risk begins.

What private credit means

Private credit means lending money to companies without using the public bond market.

A large, well-known company can often borrow by issuing bonds. A bond is basically an IOU that investors can buy and sell in public markets. But many smaller or mid-sized companies cannot easily borrow that way. They may be too small, too leveraged, or too complicated for ordinary public-bond investors.

Instead, they borrow from private lenders.

These private lenders are often asset managers, private-credit funds, insurance-linked investors, or business development companies. A business development company is a listed investment vehicle that lends money to smaller and mid-sized businesses. Ordinary investors can often buy its shares on the stock market. (1)

In plain language, private credit is this:

A company needs money.

A bank or public bond market may not want to lend on attractive terms.

A private lender steps in and offers a loan.

The company pays a high interest rate.

The private lender earns income.

Investors in the lender’s fund receive dividends or distributions.

That sounds reasonable. And in many cases, it is. Private credit is not automatically bad. It provides useful financing to companies that may otherwise struggle to borrow. It can also produce strong income for investors.

The problem comes when investors look only at the yield and forget to examine the quality of the income.

Why the market grew so quickly

Private credit grew rapidly after the global financial crisis of 2008.

After that crisis, banks faced tighter regulation. They became more careful about lending to risky or highly leveraged companies. At the same time, investors were searching for higher income because interest rates stayed very low for many years.

That created a natural opening.

Companies still needed to borrow.

Banks were more cautious.

Investors wanted higher yields.

Private-credit funds connected the two sides.

The market is now very large. Estimates vary depending on the definition used, but the Financial Stability Board has placed global private credit in the range of roughly \$1.5 trillion to \$2 trillion. That means it is no longer a small corner of finance. It is large enough that stress in private credit can matter to investors, companies, and the wider credit system. (2)

The first key risk: most private-credit loans are floating-rate

Many private-credit loans have floating interest rates.

A fixed-rate loan has an interest rate that stays the same. For example, if a company borrows at 6 per cent fixed interest, it pays 6 per cent even if market interest rates move up or down.

A floating-rate loan is different. Its interest rate moves with a benchmark rate.

The benchmark often used in United States dollar lending is the Secured Overnight Financing Rate. This is a short-term interest rate based on overnight borrowing backed by United States Treasury securities. (3)

A simple private-credit loan might be priced like this:

\[\text{Loan interest rate} = \text{Secured Overnight Financing Rate} + \text{lender spread}\]

The lender spread is the extra interest the borrower pays because it is riskier than lending against safe collateral. If the benchmark rate is 3.63 per cent and the lender spread is 5 per cent, the total interest rate is:

\[3.63\% + 5\% = 8.63\%\]

So the borrower pays 8.63 per cent a year.

Now let us make this concrete.

Suppose a company borrows \$100 million.

If the total interest rate is 5.5 per cent, the annual interest cost is:

\[\$100\text{ million} \times 5.5\% = \$100\text{ million} \times 0.055 = \$5.5\text{ million per year}\]

If the total interest rate rises to 8.63 per cent, the annual interest cost becomes:

\[\$100\text{ million} \times 8.63\% = \$100\text{ million} \times 0.0863 = \$8.63\text{ million per year}\]

The increase is:

\[\$8.63\text{ million} - \$5.5\text{ million} = \$3.13\text{ million more per year}\]

The percentage increase in the interest bill is:

\[\$3.13\text{ million} \div \$5.5\text{ million} = 0.569 = 56.9\%\]

So the company’s interest bill has increased by almost 57 per cent.

That is the danger of floating-rate debt. It can look manageable when interest rates are low, but painful when rates rise.

If the company’s profits also rise, it may cope. But if profits stay flat or fall, higher interest costs can quickly become a serious problem.

Why higher interest rates hurt leveraged companies

A leveraged company is a company with a lot of debt.

Debt is not always bad. Used carefully, it can help a company grow. But debt becomes dangerous when the company’s cash flow is not strong enough to pay interest comfortably.

Imagine a company earns \$20 million per year before interest costs.

If its interest cost is \$5.5 million, it has:

\[\$20\text{ million} - \$5.5\text{ million} = \$14.5\text{ million}\]

left before other costs, taxes, reinvestment, and profit distributions.

If its interest cost rises to \$8.63 million, it has:

\[\$20\text{ million} - \$8.63\text{ million} = \$11.37\text{ million}\]

left.

That is a reduction of:

\[\$14.5\text{ million} - \$11.37\text{ million} = \$3.13\text{ million}\]

This may not sound fatal by itself. But remember, many leveraged companies already have tight finances. They may also face weaker sales, rising wages, higher rent, or more expensive supplies.

When interest costs rise sharply, the company has less room for mistakes.

This is why private-credit stress often appears first in mid-sized, highly leveraged companies rather than in large household-name companies.

The second key risk: payment-in-kind interest

One of the most important terms to understand is payment-in-kind interest.

Normally, when a borrower owes interest, it pays cash.

For example, if a company owes \$10 million of interest this year, it sends \$10 million in cash to the lender.

Payment-in-kind interest is different. Instead of paying the interest in cash, the borrower adds the unpaid interest to the loan balance. (4)

Here is a simple example.

A company borrows \$100 million.

It owes \$10 million of interest.

But it does not pay the \$10 million in cash.

Instead, the lender allows the company to add the \$10 million to the loan balance.

The new loan balance becomes:

\[\$100\text{ million} + \$10\text{ million} = \$110\text{ million}\]

The borrower has avoided a cash payment today. But it now owes more money tomorrow.

Payment-in-kind interest can be useful in some situations. It can give a company breathing space if cash flow is temporarily weak. It may be planned from the start as part of a loan structure.

But it can also be a warning sign.

If a company cannot pay interest in cash, the investor needs to ask why.

Is the company growing and temporarily preserving cash?

Or is it struggling to survive?

Those are very different situations.

Why payment-in-kind interest can make income look better than cash reality

The accounting issue is subtle but important.

A fund may record payment-in-kind interest as income even though no cash has arrived. (4)

That means the fund’s reported income can look stronger than its cash income.

Let us use a simple example.

Suppose a fund reports \$100 of investment income.

Out of that \$100:

\$87.50 is cash interest actually received.

\$12.50 is payment-in-kind interest added to loan balances.

The fund’s reported income is still:

\[\$87.50 + \$12.50 = \$100\]

But the cash received is only \$87.50.

The difference is:

\[\$100 - \$87.50 = \$12.50\]

of non-cash income.

That does not automatically mean fraud. It does not mean the accounting is illegal. It means the investor must distinguish between income recorded on paper and income received in cash.

This matters because income investors often focus on dividends.

If a fund pays a large dividend, investors may assume the fund is healthy. But a dividend can be supported by a mixture of cash income, non-cash income, realised gains, borrowing, capital recycling, or return of capital.

A dividend is not proof of health by itself.

Business development companies and the 90 per cent distribution rule

Business development companies have a special tax structure.

In simple terms, those that elect to be treated as regulated investment companies can generally avoid corporate-level tax if they distribute most of their taxable income to shareholders. The usual minimum is 90 per cent of investment-company taxable income. (5)

Here is the simple formula:

\[\text{Minimum required distribution} = \text{taxable income} \times 90\%\]

If taxable income is \$100 million, the minimum distribution is:

\[\$100\text{ million} \times 90\% = \$100\text{ million} \times 0.90 = \$90\text{ million}\]

That sounds shareholder-friendly. Investors receive a lot of income.

But there is a complication.

If some taxable income is not received in cash, the company may still need to distribute cash to shareholders. That can create pressure.

Imagine a business development company reports \$100 million of taxable income.

Suppose \$12.5 million of that is payment-in-kind interest.

Cash income is therefore:

\[\$100\text{ million} - \$12.5\text{ million} = \$87.5\text{ million}\]

But the minimum distribution requirement is:

\[\$100\text{ million} \times 90\% = \$90\text{ million}\]

The cash income is \$87.5 million.

The required distribution is \$90 million.

The gap is:

\[\$90\text{ million} - \$87.5\text{ million} = \$2.5\text{ million}\]

This is a simplified example, but it shows the logic.

The fund may still be able to pay the dividend using other cash sources. But the quality of the dividend is weaker than it looks if a meaningful part of income is non-cash.

That is why investors should not only ask:

“What is the dividend yield?”

They should ask:

“How much of the income was actually received in cash?”

A high yield can be a warning, not a bargain

A yield of 10 per cent or 11 per cent can look attractive.

But a high yield can mean two very different things.

It can mean:

The investment is genuinely producing strong cash income.

Or it can mean:

The market thinks the investment is risky, so the share price has fallen, making the yield look high.

Here is a simple example.

Suppose a fund pays \$1 per year in dividends.

If the share price is \$20, the dividend yield is:

\[\$1 \div \$20 = 0.05 = 5\%\]

If the share price falls to \$10, but the dividend stays at \$1, the yield becomes:

\[\$1 \div \$10 = 0.10 = 10\%\]

The dividend did not improve.

The business did not become safer.

The yield doubled because the share price fell.

This is why very high yields require careful analysis. Sometimes they are opportunities. Sometimes they are warnings.

What net asset value tells us

Net asset value means the estimated value of a fund’s assets minus its liabilities.

In plain English:

\[\text{Net asset value} = \text{what the fund owns} - \text{what the fund owes}\]

For a fund holding public stocks, net asset value is easier to observe because market prices are available every day.

For a private-credit fund, valuation is harder. Many loans do not trade on an exchange. There may be no daily market price. The fund must estimate fair value using models, borrower financial information, discount rates, comparable loans, and valuation processes.

This does not mean the valuation is fake. It means the valuation is less directly observable.

That creates a risk called valuation lag. Financial Stability Board analysis identifies opacity and valuation uncertainty as vulnerabilities in private credit. (2)

Valuation lag means the reported value may adjust more slowly than the true economic stress inside the portfolio.

If a borrower is weakening, the loan may not immediately be marked down to a distressed level. But eventually, if the borrower cannot pay, refinance, or recover, the valuation must reflect reality.

A real example: FS KKR Capital

FS KKR Capital is one of the large publicly traded business development companies.

It provides a useful example of why investors need to read below the dividend yield.

In 2025, payment-in-kind interest represented \$224 million, or 14.7 per cent, of FS KKR Capital’s \$1.519 billion total investment income. That is a high proportion of non-cash interest income. (6)

In the first quarter of 2026, the company’s own filing showed payment-in-kind interest was 12.5 per cent of total investment income. (4)

That means a meaningful part of its reported income was not cash interest received immediately.

The company also reported that investments on non-accrual status were 4.2 per cent of the portfolio at fair value at the end of March 2026. (4)

Non-accrual status means the lender no longer expects to collect interest reliably enough to keep recording it as normal income. In plain language, it is a warning label on a loan.

FS KKR Capital’s net asset value per share also fell from \$20.89 at the beginning of the first quarter of 2026 to \$18.83 at the end. (4)

The fall was:

\[\$20.89 - \$18.83 = \$2.06\]

The percentage decline was:

\[\$2.06 \div \$20.89 = 0.0986 = 9.86\%\]

So the net asset value per share fell by about 9.9 per cent in one quarter.

That is a meaningful deterioration. It does not mean the company is worthless. It does not mean the whole private-credit market is collapsing. But it does show why investors must look beneath the dividend.

Why maturity dates matter

Every loan has a maturity date.

The maturity date is the date when the borrower must repay the loan or refinance it.

Refinancing means replacing an old loan with a new loan.

This is where problems can appear.

If a company borrowed money when interest rates were very low, it may have survived for years with manageable debt costs. But when the loan matures, it may need to refinance at today’s higher rates.

If the company was already struggling to pay interest, refinancing can become difficult.

The borrower may face three possibilities:

It finds a new lender and refinances.

It negotiates with existing lenders to extend the loan.

It restructures, meaning lenders accept losses, convert debt into ownership, or take control of the company.

A maturity wall means many loans coming due in a short period. If many weak borrowers need refinancing at the same time, lenders become more selective. That can turn a slow credit problem into a sharper one.

The main lesson for investors

The most important lesson is simple:

Income is not the same as safety.

A fund can pay a high dividend while some borrowers are becoming weaker.

A loan can be labelled performing while the borrower is relying on payment-in-kind interest.

A fund can report income that includes amounts not yet received in cash.

A private loan can be valued using a model rather than a daily market price.

None of this means every private-credit fund is dangerous. But it means investors must analyse the structure carefully.

The checklist investors should use

Before buying a high-yield private-credit fund or business development company, investors should ask the following questions.

How much of the income was received in cash?

How much came from payment-in-kind interest?

Are non-accrual loans rising?

Is net asset value per share falling?

Is the dividend covered by cash income, or only by accounting income?

Are borrowers heavily exposed to floating-rate debt?

When do the loans mature?

Are valuations based on active market prices or modelled estimates?

Is the share price trading far below net asset value, and if so, why?

These questions matter more than the headline yield.

Final thought

Private credit is not automatically bad. It plays a real role in financing companies. It can produce attractive income. Skilled lenders can manage risk well.

But private credit is also entering a more difficult environment than the one in which it grew so quickly. Higher interest rates, weaker borrowers, payment-in-kind income, refinancing pressure, and less transparent valuations all require serious attention.

The danger is not that investors own private credit.

The danger is that they may own it without understanding what is underneath the yield.

A high dividend can be income.

It can also be a warning.

The difference is found in the cash.