Our Chief Fixed Income Strategist Vishy Tirupattur and Leveraged
Finance Strategist Joyce Jiang discuss how the dynamic between
private and public credit markets will evolve in 2025, and how
each can find their own niches for success.
----- Transcript -----
Vishy Tirupattur: Welcome to Thoughts on
the Market. I am Vishy Tirupattur, Morgan Stanley's Chief Fixed
Income Strategist. Today we'll be talking about how private
credit has evolved over 2024 and the outlook for 2025. I'm joined
by my colleague, Joyce Jiang, from our Leveraged Finance Strategy
team.
It's Tuesday, December 3rd at 10am in New York.
A lot has happened over 2024 in private credit. We are credit
people. Let's talk about defaults and returns. How has 2024 been
thus far for private credit in terms of defaults and returns?
Joyce Jiang: It's always tricky to talk
about defaults in private credit because the reported measures
tend to vary a lot depending on how defaults are defined and
calculated. Using S&P's credit estimate defaults as a proxy
for the overall private credit defaults, we see that defaults
appear to have peaked, and the peak level was significantly lower
than during the COVID cycle.
Since then, defaults have declined and converged to levels seen
in public loans. In this cycle, the elevated policy rates have
clearly weighed on the credit fundamentals, but direct lenders
and sponsors have worked proactively to help companies extending
maturities and converting debt into PIK loans. Also, the high
level of dry powder enabled both private credit and PE funds to
provide liquidity support, keeping default rates relatively
contained.
From a returns perspective for credit investors, the appeal of
private credit comes from the potential for higher and more
stable returns, and also its role as a portfolio diversifier.
Data from Lincoln International shows that over the past seven
years, direct lending loans have outperformed single B public
loans in total return terms by approximately 2.3 percentage point
annually, largely driven by the better carry profile. And this
year, although the spread premium has narrowed, private credit
continues to generate higher returns.
So, Vishy, credit spreads are close to historical tights. And the
market conditions have clearly improved compared to last year.
With that, the competition between the public and private credit
has intensified. How do you see this dynamic playing out between
these two markets?
Vishy Tirupattur: The competition between
public and private credit has indeed intensified, especially as
the broadly syndicated market reopened with some vigor this year.
While the public market has regained some share it lost to
private credit, I think it is important to note that the activity
has been, especially the financing activity, has been really more
two-way. Improved market conditions have lured some of the
borrowers back to the public markets from private credit markets
due to cheaper funding costs.
At the same time, borrowers with lower rating or complex capital
structure seem to continue to favor private credit markets. So,
there is really a lot of give and take between the two markets.
Also, traditionally, private credit markets have played a major
role in financing LBOs or leveraged buyouts. Its importance has
really grown during the last Fed's hiking cycle when elevated
policy rates and bouts of market turmoil weaken banks’ risk
appetite and tighten the public-funding access to many leveraged
borrowers.
Then, as the Fed's policy tightening ended, and uncertainty about
the future direction of policy rates began to fade, deal activity
rebounded in both markets, and more materially in public markets.
This really led to a decline in the share of LBOs financed by
private credit. Of course, the two markets tend to cater for
deals of different sizes. Private credit is playing a bigger role
in smaller size deals and a broadly syndicated loan market is
relatively much more active in larger sized LBOs. So, overall,
public credit is both a complement and competitor
to private credit markets.
Joyce Jiang: The decline in spread basis is
evident in larger companies, but more recently, the spread
basis have even compressed within smaller-sized deals, although
they don't have the access to public credit. This is likely due
to some private credit funds shifting their focuses to deals down
in the site spectrum. So, the growing competition got spilled
over to the lower middle-market segment as well. In addition to
pricing conversions, we've also seen a gradual erosion in
covenant quality in private credit deals. Some data sources noted
that covenant packages have increasingly favored borrowers, a
reflection of the heightened competition between these two
markets.
So Vishy, looking ahead, how do you see this competition
between public and private credit evolving in 2025, and what
implications might this have for returns?
Vishy Tirupattur:, The competition, I
think, will persist in [the ]next year. We have seen strong
demand from hold to maturity investors, such as insurance
companies and pension funds; and this demand, we think, will
continue to sustain, so the appetite for private credit from
these investors would be there.
On the supply side, the deal volume has been light over the last
couple of years. Next year, acquisition LBO activity, likely to
pick up more materially given the solid macro backdrop, lower
rates that we expect, and sponsor pressure to return capital to
investors. So, in 2025, we could see greater specialization in
terms of deal financing. Instead of competing directly for deals,
public and private credit markets can find their own niches. For
example, public credit might dominate larger deals, while private
credit could further strengthen its competitive advantage within
smaller size deals or with companies that value its unique
advantages, such as the flexible terms and speed of execution.
Regarding returns, while spread premium in private credit has
indeed come down, a pickup in deal activity could to some extent
be a release valve. But sustained competition may keep the
spreads tight. Overall, private credit should continue to offer
attractive returns, although with tighter margins compared to
historical levels.
Joyce, it was great speaking with you on today's podcast.
Joyce Jiang: Thank you, Vishy, for having
me.
Vishy Tirupattur: Thank you all for
listening. If you enjoy today's podcast, leave us a
review wherever you listen and share Thoughts on the Market with
a friend or colleague today.
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