Forward Guidance

The Rising Risks In The “Private Credit” Lending Bonanza | Andrzej Skiba

Thu Feb 15 2024

private creditfixed incomeinvestmenteconomic slowdownleverage loanshigh yield bondsdefault ratesrate cutsresiliencyreal estate

Description

Private credit is the fastest growing part of fixed income markets. It involves lending to companies outside of public markets, with various investment styles. Private credit offers potential for double-digit returns but carries higher risk. Smaller, less diversified companies are often the focus. Economic slowdowns can impact private credit investments. Companies paying debt linked to floating rates face pressure in high interest rate environments. Refinancing debt helps avoid higher costs of funding. Private credit intersects with other parts of the fixed income universe. The rise of private credit affects leverage loans and high yield bonds. Default rates are higher in private credit and leverage loan spaces. The US economy's resiliency is driven by low inflation rates and aggressive rate cuts. The neutral rate and future rate cuts are uncertain. High yield issuance has fallen due to rising interest rates. There are investment opportunities in real estate and other areas. Fixed income investors should avoid herd mentality and focus on specific issuers and securities.

Insights

Private credit is the fastest growing part of fixed income markets.

Private credit involves lending to companies outside of public markets, with various investment styles. It offers potential for double-digit returns but carries higher risk.

Companies paying debt linked to floating rates face pressure in high interest rate environments.

Refinancing debt helps avoid higher costs of funding. Economic slowdowns can impact private credit investments.

The rise of private credit affects leverage loans and high yield bonds.

Default rates are higher in private credit and leverage loan spaces. The US economy's resiliency is driven by low inflation rates and aggressive rate cuts.

High yield issuance has fallen due to rising interest rates.

There are investment opportunities in real estate and other areas. Fixed income investors should avoid herd mentality and focus on specific issuers and securities.

Chapters

Private Credit Overview
Risks and Challenges in Private Credit
Challenges and Risks in Private Credit (Continued)
Private Credit and its Impact on the Fixed Income Market
Competition and Outlook for Private Credit
Default Rates and Market Outlook
Market Expectations and Investment Opportunities
Resiliency of the US Economy and Rate Cuts
Investment Strategies and Fixed Income Market Behavior
Challenges in the Fixed Income Industry

Summary

Transcript

Private Credit Overview

00:00 - 07:52

Private credit is the fastest growing part of fixed income markets.
Private credit involves lending to companies outside of public markets, through direct agreements with one or two lenders.
The private credit space includes various investment styles, such as infrastructure assets and distressed investing.
Investors are drawn to private credit because of the potential for double-digit returns.
Lack of market-to-market accounting in private credit provides a sense of security for investors.
However, private credit carries higher risk compared to government bonds or investment-grade rated credit.
Smaller, less diversified companies that lack access to public funding are often the focus of private credit investments.
These companies may be more vulnerable during economic slowdowns.

Risks and Challenges in Private Credit

07:23 - 15:33

Private companies that have limited access to public markets for funding are at a higher risk during an economic slowdown compared to their counterparts in the public market.
Companies paying debt linked to floating rates, such as LIBOR or SOFR, are under pressure in a high interest rate environment.
Many companies have been proactive in refinancing their debt, which has helped them avoid higher costs of funding when interest rates increase.
Leveraged loan and private credit companies face increased costs of funding with every rate hike, leading to low cash flow and limited resources for other expenses.
The private debt space is particularly vulnerable during economic uncertainty and a potential slowdown due to high costs of debt.
Private equity sponsors, who mainly own companies accessing private credit and direct lending, may not be able to help all struggling companies if the situation continues.
The majority of companies in the private credit space are paying double-digit costs of funding, indicating widespread issues.
Private equity-owned companies often run with high leverage to improve equity returns for owners.
Private equity firms choose private credit markets over public high-level debt markets to finance leveraged buyout (LBO) deals for better returns.
Ad bags refer to non-cash items that owners add to the profitability of businesses when marketing transactions. They can include contracts not yet won or synergies from M&A transactions that haven't been realized yet. Some ad bags may be aggressive and rely on outcomes that may or may not materialize.

Challenges and Risks in Private Credit (Continued)

15:03 - 23:01

Ad bags that include full-year business numbers are used for comparison, but many ad bags are aggressive and may not materialize.
Bond markets traditionally do not accept aggressive ad bags like the leverage loan or private credit space does.
The private credit industry has not been tested in a broad, longer slowdown or recession.
Investors need to be careful and understand the risks associated with allocating capital to the fixed income market.
Different economic scenarios can impact the performance of private credit, with more benign scenarios being preferable.
Private credit loans are bilateral agreements, which means selling them can be difficult if anything goes wrong.
Customized agreements in private credit come with higher returns but also higher risks due to less liquidity.
Debt covenants in private credit provide lenders with control over companies to protect their capital, but standards have fallen as more money enters the asset class.

Private Credit and its Impact on the Fixed Income Market

22:45 - 30:36

Private credit has seen a significant increase in investment over the recent years, leading to weaker documentation and lower extra compensation.
The promise of no market-to-market and the belief in selecting good managers have attracted a large amount of money into private credit, with over $200 billion per annum flowing into the space.
After the traumatic events of 2022, where both stocks and fixed income experienced significant declines, investors were hesitant to invest in traditional high-yield bonds. Instead, they turned to private debt as a safer option.
Private credit intersects with other parts of the fixed income universe through macro events. The biggest tug-of-war is between broadly syndicated leverage loans and private credit.
As money flowed aggressively into private credit, it started refinancing obligations within the leverage loan space, causing it to shrink for the first time in ages.
While this resulted in less activity in leverage loans, it provided a home for riskier companies that had difficulty refinancing in the public market, helping to avoid defaults and smooth out the credit cycle.

Competition and Outlook for Private Credit

30:21 - 38:00

Private credit has become a popular alternative for companies looking to refinance and avoid default, benefiting leverage loan investors.
There is competition between the leverage loan market and private credit, with investors willing to snatch deals away from leverage loans.
The high yield bond market is mainly used for refinancing, while new transactions happen in the leverage loan and private credit spaces.
Private credit deals are often used for financing leveraged buyouts (LBOs) and dividend recapitalization.
Repricings in the leverage loan space have led to more confidence in economic outlook and acceptance of dividend distributions funded by secured loans.
The rise of private credit can make the high yield bond market less risky as defaults are taken out of it and put into private credit.
Private credit provides an avenue to avoid default when there are only a few problem credits, but if there is a broader issue with cash flow generation, it becomes a bigger problem that affects the entire market.

Default Rates and Market Outlook

37:44 - 46:14

The default rates in the public high yield market are currently low, but the leverage loan and private credit space have higher default rates.
The high yield bond issuers have a benign default outlook due to the lack of maturities this year.
Companies in the public high yield space have used their cash flows to strengthen their balance sheets, resulting in lower leverage compared to private credit spaces.
The default outlook for private credits and leverage loan spaces could lead to double-digit defaults if there is a lack of cash flow and limited ability to refinance.
There is a significant difference in relative strength between the public high yield space and other parts of the market, leading to less exciting spreads within the high yield bond space.
Blue Bay advises clients to gradually move away from money market investments and be more brave by going further out on the duration curve within credit or securitized spaces.
There is potential for double-digit returns in fixed income portfolios by making accurate calls on rate direction, Federal Reserve actions, and economic progress.
Waiting for more clarity on inflation data and Fed policy may be wise before making investment decisions.
Five or ten-year treasuries are becoming interesting as the market moderates its pricing of rate cuts.

Market Expectations and Investment Opportunities

45:47 - 54:01

Stronger labor data and elevated inflation print have led to a change in market expectations for rate cuts.
Active management in US aggregate investments can help navigate the market and find attractive opportunities.
Investing in high yield spaces can lead to double-digit returns, while investment grade requires more factors to cooperate for a 10% return.
There is debate about when the first interest rate cut by the Fed will happen and what the terminal rate will be.
The resiliency of the US economy has been driven by companies not making layoffs and middle class spending during higher rate regimes.

Resiliency of the US Economy and Rate Cuts

53:33 - 1:01:10

The US economy has two factors that increase its resiliency: low inflation rates and the ability of the Fed to cut rates more aggressively.
Inflation is likely to settle above the 2% target set by the Fed, which means that yields on 10-year treasuries are less likely to be as low as 1.5%.
There is no agreement on what the neutral rate is, which is the rate where the economy doesn't get better or worse and can tolerate it relatively easily.
The Fed funds rate could normalize between 2% to 3%, but there is a risk that inflation remains stickier and limits the ability to cut rates further.
Fewer rate cuts ahead may lead investors to stay in money markets or short duration instruments rather than going further out on the yield curve.
The yield curve is expected to normalize in this cycle, but it depends on continued moderation of inflation. If inflation doesn't moderate, there could be fears of rate hikes and a more pronounced economic slowdown.
Companies have a high yield maturity wall in the future, with an increase in maturities from mid-2025 onwards. Refinancing these maturities would be welcome for market stability.
Liquidity and access to refinancing are crucial for companies. Currently, companies have low leverage and low funding costs in the high yield bond space.

Investment Strategies and Fixed Income Market Behavior

1:00:53 - 1:08:23

High yield issuance was high in 2020-2021 but fell off in 2022 due to rising interest rates.
Despite lower issuance, it is not due to a lack of liquidity; companies have control and can issue if they want.
Spreads in the high yield market have been well-behaved due to scarcity of bonds.
There are corners of the market to avoid and others with good investment opportunities.
In the real estate space, office real estate has been hit hard, but there are opportunities in warehouses, leisure properties, and multifamily residential properties.
Selecting assets requires thorough research as different locations can have different futures.
The single asset single borrower market within CMBS (commercial mortgage-backed securities) is more appealing than the conduit market for investing in real estate.
In the single asset single borrower market, bonds are issued by specific issuers with exposure to certain underlying assets.
This market is less liquid and requires longer holding periods before realizing value.
Fixed income investors often make the mistake of following herd mentality instead of conducting independent analysis.

Challenges in the Fixed Income Industry

1:07:55 - 1:12:34

Fixed income investors often exhibit herd mentality, following popular themes and bandwagons.
Short-term catalysts, such as data releases, receive excessive focus compared to long-term market direction.
The fixed income industry has expanded significantly since the global financial crisis, resulting in larger asset managers with reduced maneuverability and reliance on beta drivers.
Emphasizing specific issuers, companies, and securities rather than predicting overall market movements is more valuable.
Overshooting occurs during sell-offs and rallies due to the inability of large players to be nimble in repositioning their portfolios.