On Feb. 27, State Street Global Advisors launched the SPDR SSGA Apollo IG Public & Private Credit ETF (PRIV). It’s among the first exchange-traded funds to give retail investors access to the fast-growing asset class known as private credit.

Khang Nguyen, the chief credit officer of registered investment advisor Heron Finance, broke down private credit in simple terms in an email interview.

“Private credit primarily refers to non-publicly traded, privately negotiated loans between a borrower and a non-bank lender,” Nguyen said.

Non-bank lenders, also known as “shadow banks,” include hedge funds, mortgage lenders, and other financial institutions that are not bound by banking regulations.

Bonds, by contrast, are publicly-traded loans from a bank. According to Nguyen, post-Great Recession financial regulations have limited banks’ ability to lend, especially to private equity-backed companies that may not have all the paperwork needed to borrow money from banks at competitive interest rates.

That “regulatory workaround” appeal — along with the strong performance of private credit investments — has helped private credit grow rapidly into a $2 trillion industry as of December 2023, according to a report by McKinsey

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Until recently, private credit was… private. The loans (which function much like bonds, providing interest payments and potential capital gains to investors) were unavailable to anyone except the financial institutions that made them, and very wealthy individuals.

But in recent years, several private credit ETFs, including State Street’s PRIV ETF, the Virtus Private Credit Strategy ETF (VPC) and the BondBloxx Private Credit CLO ETF (PCMM) have launched, opening up private credit to anyone with a brokerage account.

Some robo-advisor firms, such as Titan and Fidelity Go, have also launched private credit-based investment strategies (though Fidelity Go’s is only open to accredited investors). But before you invest in this novel asset class, it’s worth understanding its unique pros and cons.

High and stable returns are one of the upsides of private credit. The asset class averages returns of 9% to 11% per year, Nguyen says, which is significantly higher than what you’d earn with many bond funds.

However, there are some significant downsides to keep in mind. Nguyen said that some private credit investments are illiquid — you aren’t necessarily allowed to pull your money out whenever you want, like you can with most conventional investments.

Titan’s private credit strategy, for example, only allows quarterly withdrawals, and also has a $2,500 minimum.

Private credit ETFs such as PRIV do offer daily liquidity, like most other ETFs. But regulators say that might not be a good thing, given that their underlying private credit investments can’t be bought and sold on demand like stocks.

If a large number of investors sold shares of the ETF, for example, and the ETF was unable to sell a corresponding amount of its private credit investments, that could cause the price of the ETF to diverge sharply from the actual value of its holdings. Hours after PRIV started trading, the SEC sent State Street a letter expressing “concerns regarding the Fund’s liquidity risk management program,” according to a report by Bloomberg.

Nguyen added that the private credit industry is “relatively young and filled with many inexperienced managers, and has not experienced a systemic correction or significant downturn since its inception.” Given that private credit is less regulated than conventional fixed-income investments, such as bonds, it’s hard to predict how bad a downturn might be.

Private credit is growing fast — and offering investors much higher returns than many bonds pay — because it fills a demand for quick-and-easy financing from companies that aren’t established enough to borrow money conventionally.

But it’s very new to retail investors, and doesn’t always offer features that most conventional investments do, like on-demand withdrawals. Plus, that lack of regulation could also leave it vulnerable to a big crash in the future.

If this sounds too risky to you, traditional bonds may be a better way to diversify your portfolio.