A Golden Era for Private Credit?
High interest rates are boosting returns from the floating rates offered by private credit, and spreads are currently highly attractive. This is helping to offset the threat of rising default rates as borrowing costs remain elevated and global growth slows.
The private credit sector has grown rapidly over the past 10 years – with annual growth in assets under management of around 10% per annum – to reach a value of US$1.5 trillion.[i], [ii] As banks have cut back on lending, borrowers have been flocking to direct lenders.
Now the sector is also being tipped to enter a “golden” era in terms of returns.[iii] This view reflects favourable conditions such as spread widening, higher base rates and more conservative deal structures due to lower leverage, larger equity contributions and tighter loan documentation, according to Fund Selector Asia.
Higher base rates help because direct loans tend to offer a floating rate, as opposed to the fixed rates that public-market bonds pay. Moreover, the private nature of the loans means their value doesn’t fluctuate as much as leveraged loans or traditional bonds, which have proven particularly volatile over the past two years as interest rates have surged. Those lower levels of volatility are highlighted in the table below.
Figure 1: Direct loans exhibit much lower levels of volatility than counterparts
However, the opportunities in private credit also entail risk as global growth slows and borrowing costs remain elevated for the foreseeable future. An increase in defaults is likely. UBS forecasts that the default rate of private-credit borrowers will peak at 9–10% in early 2024, before falling back to about 5–6% as the Federal Reserve cuts rates.[iv] These defaults are likely to be concentrated among highly leveraged companies exposed to cyclical sectors.
Yet private credit remains very attractive, given high spreads over benchmarks such as the Secured Overnight Financing Rate (SOFR). The SOFR is currently above 5%, yet new private loans are offering yields of 12% or more. Indeed, Jeffrey Jaensubhakij, the chief investment officer of Singapore Wealth Fund GIC, has said private credit is the asset class that currently offers the “most attractive” risk/reward profile.[v]
That attractive profile is attracting new investors such as the Japanese insurers Dai-ichi Life Insurance and Nippon Life Insurance. The Bank of Japan’s decision to maintain its easy monetary policy stance at a time when other central banks are tightening has caused the yen to weaken and made the cost of hedging foreign bond investments prohibitively expensive. That’s pushing Japanese insurers to grab the premiums offered by illiquid assets such as private credit.[vi]
Elsewhere, Abu Dhabi’s sovereign wealth fund, one of the world’s largest, recently announced it would double its investment in an Australian real-estate private credit vehicle. One of South Korea’s major pension funds, meanwhile, is targeting the sector as an alternative to “very volatile” stocks and bonds, according to Baek Joohyun, chief investment officer of the Government Employees Pensions Service. The Service plans to raise its investments in this category, which includes private credit and real-estate loans, to 34% in the next four years, from about 28% aimed for this year.[vii]
In conclusion, the appeal of private credit is clear. However, given the prospects of rising default rates, careful scrutiny of borrowers is vital, while cyclical sectors could be hit if the global economy weakens significantly over the next year.
Key takeaways
Positive factors in private credit include spread widening, higher base rates and more conservative deal structures due to lower leverage, larger equity contributions and tighter loan documentation.
However, rising default rates are accompanying the opportunities as global growth slows and borrowing costs remain elevated for the foreseeable future.
Careful analysis and a focus on well-managed businesses in non-cyclical areas can mitigate these risk factors.
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