Our analysts Vishy Tirupattur and Joyce Jiang discuss the health
of private credit as default pressures are building for borrowers
amid weaker growth, fewer rate cuts and policy uncertainty.
Read more insights from Morgan Stanley.
----- Transcript -----
Vishy Tirupattur: Welcome to Thoughts on
the Market. I am Vishy Tirupattur, Morgan Stanley's Chief Fixed
Income Strategist.
Joyce Jiang: And I'm Joyce Jiang, U.S.
Leverage Finance Strategist.
Vishy Tirupattur: Today we'll take a look
at private credit markets. Will it stay resilient in the current
macro conditions? Or a reckoning is ahead of us.
It's Tuesday, May 13th at 10am in New York.
Tariffs and policy uncertainty are on the top of mind for people
with an eye on the economy and markets. Certainly, a frequent
topic of discussion for us on this podcast. In this environment,
there has been growing concern about the health of corporate
credit – and within corporate credit direct lending or middle
market segments, where companies tend to be smaller in size and
have weaker fundamentals are of particular concern. The business
models of these companies are sensitive to slower growth.
Joyce, can you map out the risks associated with private credit
companies?
Joyce Jiang: To your point, risks are
rising in private credit, but I think these risks would be
measured given the still resilient fundamental backdrop. Looking
at fundamental trends, there is no clear sign of leverage
building up in the system yet, and multiple data sources actually
show that the leverage ratios among direct lending companies have
either improved or remained flat. And that's very different from
the previous cycles where excessive corporate leverage set the
stage for the eventual downturn.
So, this time around credit, including both public credit and
private credit, is not the source of the problem. But, of course,
these direct lending companies would be impacted by higher
tariffs. So, Vishy what's your view on the tariff impact?
Vishy Tirupattur: So, the direct impact of
tariffs, Joyce, we think is likely to be muted. It's quite hard
to quantify this exposure, but if you look at a number of
different data sources, we find that the direct lending loans are
more skewed towards defensive and service-oriented sectors.
For example, sectors such as a technology, business services and
healthcare account for over half of the loans in typical BDC
portfolios or Business Development Company portfolios of direct
lending loans. But that said, even though the direct impact could
be somewhat limited, there could be second order effects because
there is higher uncertainty and weaker confidence, and that could
weigh on demand. There could be a tail cohort that could be
developing.
So, some data from Lincoln International, for example, shows that
about 15 per cent of direct lending companies have EBITDA
interest coverage ratio below 1x. Another way of looking at tail
cohort is by looking at companies generating negative free
operating cash flow. According to S&P data, that's about 40
per cent. These tail cohorts are stretched and are weakly
positioned to weather macro challenges ahead.
So, Joyce, another thing that comes up frequently when we talk
about private credit is Payment In Kind interest or the so-called
PIK interest. Can you walk us through what is a PIK and why is it
a concern?
Joyce Jiang: So, Payment In Kind interest –
it occurs when the company stops paying interest in cash, but
instead the interest is accrued and added to the
principal balance. It is quite common for
companies under liquidity stress to switch to PIKs for cash
preservation, But in many cases, PIKs don't really clean up the
company's balance sheet, and the companies may still end up in a
conventional default. So, PIK is generally considered as a
leading indicator of default by market participants.
And to be clear, not all PIK loans are bad. PIK toggles are
actually a key feature that distinguishes direct lending loans
from syndicated loans because it provides non-distressed
companies the flexibility to reallocate cash for other business
needs. So, PIKs do not necessarily signal higher defaults. And in
fact, data showed that BDCs or Business Development Companies
with a higher PIK income don't always see a greater increase in
nonaccruals. So, in other words, the relationship between PIK
income and defaults is not persistently strong.
Vishy Tirupattur: So, to summarize, overall
fundamentals are on a relatively strong footing, but risks in
private credit are rising, especially if we have a potential
economic slowdown ahead. On the other hand, there are a few
structural features with the private credit loans that could
potentially help mitigate some of the vulnerabilities we've just
talked about.
First thing, direct lending loans are not marked to market by
design, so they have lower volatility and are relatively immune
from daily price moves. And really related to that, redemption
risk of private credit funds has been fairly contained so far.
These funds usually have tools like lockup periods and redemption
caps to guard against unexpected large outflows.
But of course, the effectiveness of these mechanisms has not yet
been tested in severe downturns. Moreover, the capital that is
going into private credit is relatively sticky capital. Key
investors, such as insurance companies and pension funds are
hold-to-maturity type buyers, and they're entering in the space
for the attractiveness of the higher yields and to harvest
illiquidity premia embedded in these loans. So, with that
long-term investment horizon, they would be more willing to
support companies through temporary liquidity challenges. Also,
small lender groups in direct lending market makes it easier to
negotiate restructurings.
Joyce Jiang: Lastly, there is also ample
dry powder. According to PitchBook, there is $570 billion of dry
powder in private debt fund, and another $2 trillion in private
equity funds. And this capital can be deployed to backstop
distressed companies and help keeping defaults in check. And in
terms of defaults, we are expecting syndicated loan defaults to
end the year at 4 per cent. And that's our base case.
And based on the historical relationship, that implies a like for
like default rate for perfect credit at 5 per cent, which means a
mild uptake from the current level, but is still below the COVID
peak.
Vishy Tirupattur: Joyce, thanks for taking
the time to talk about this.
Joyce Jiang: Thanks for having me, Vishy.
Vishy Tirupattur: And to our listeners,
thank you for your attention. Let us know what you think of this
podcast and the topics we cover. And if you think a friend or a
colleague might find this information useful, please share
Thoughts on the Market with them today.
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