Our Global Head of Fixed Income Andrew Sheets and Head of U.S.
Credit Strategy Vishwas Patkar discuss what’s driving record debt
issuance and growing worries about private credit.
Read more insights from Morgan Stanley.
----- Transcript -----
Andrew Sheets: Welcome to Thoughts on the
Market. I'm Andrew Sheets, Global Head of Fixed Income Research
at Morgan Stanley.
Vishwas Patkar: And I'm Vishwas Patkar, Head of
U.S. Credit Strategy at Morgan Stanley.
Andrew Sheets: And today on the program, we're
going to talk about two of the biggest questions facing global
credit markets. A rush of issuance and questions around private
credit.
It's Friday, March 27th at 2pm in London.
Vishwas, it's great to have you in town, talking over what I
think are two of the biggest questions that are hanging over the
global credit market. A large wave of issuance and a lot of
questions around a segment of that market, often known as private
credit.
So, let's dig into those in turn. I want to start with issuance.
You know, you and your team had a pretty aggressive forecast at
the start of the year, for a significant level of supply. How's
that going? How is it shaping out? We're now almost through the
first quarter…
Vishwas Patkar: Yeah. So, we came into the year
expecting a record, [$]2.25 trillion of gross issuance in
investment grade. That's 25 percent higher than last year. That
would mark a record one year number for investment grade. And for
the high yield market, we expected about [$]400 billion of
issuance; up roughly 30 percent.
If I were to mark to market those, the forecast is roughly
playing out as expected through mid-March. IG issuance is up
about 21 percent. High yield issuance is up about 25 percent. So
far at least, it's along the lines of what we'd call for. More
importantly though, when I think about the drivers of the
issuance, that I think in some ways is a little more validating.
Because there were two big components of what was going to drive
the issuance.
One was AI related issuance from the large hyperscalers, and the
second was a decent uptick in M&A. And we've seen both of
those. So, year-to-date, we've had north of [$]80 billion of
issuance from hyperscalers alone in the dollar market. That's on
top of significant non-USD issuance that we've had this year.
So, I think this idea of AI CapEx investments and by extension
issuance being somewhat agnostic to macro, that seems to be
playing out so far.
Andrew Sheets: So, let's talk a little bit more
about that – because, you know, this is a new development. This
kind of is a new regime to have this much supply, sort of,
somewhat independent of a very volatile macro backdrop.
And you know, maybe if you could talk just a little bit more
about what we're learning about the issuers. What do they care
about? What is bringing them to market? And then maybe what would
cause them to slow down or speed up?
Vishwas Patkar: Yeah, I think we've learned a
couple of things, right? First is – this issuance is being driven
by investments that are not opportunistic, right? They are
competitive in nature. Clearly there is an arms race to figure
out who will win the AI race.
I think a second leg of it is the issuance is somewhat spread
agnostic. So, you know, in credit we look at this metric called
new issue concessions, which is effectively how much is a company
paying in terms of excess funding costs relative to their bonds
outstanding. And what we've seen with some of the larger deals is
that new issue concessions are well above average.
And that's pretty important in the grand scheme of things
because, you know, we're talking about one sector that is driving
AI infrastructure. But when you have issuance that comes in size,
and it comes wide to where existing bonds are, we think that has
knock-on effects repricing other companies that are downstream of
those names.
Andrew Sheets: So, we have a market for issuing
corporate debt that's pretty wide open. You know, as you
mentioned, very high levels of issuance and supply going through,
despite what would've been a lot of concerns. And one of those
concerns is the conflict in Iran.
But another concern that's been cropping up is a concern around
this market often known as private credit where you've seen a lot
of focus, a lot of headlines, volatility in some of the managers
of private credit. But also, I think this is an area where less
is known. And where there's still a lot of confusion about what
it is and how it's performing.
So, for the second set of questions, Vishwas, maybe we could just
start with, you know, when you think about private credit, what
is it to you? And how do you break up the market?
Vishwas Patkar: Yeah, so I think at a very high
level, you can think about private credit as capital that is
provided by non-bank lenders. And in some ways – that is not
broadly syndicated. So it's different from investment grade bonds
or high yield bonds or leverage loans in that respect. You know,
the second factor I laid out.
You know, private credit overarchingly is a big umbrella term. It
includes direct lending to businesses. It includes infrastructure
finance, project finance, the private placement market,
asset-based finance. So, there are a lot of subcomponents.
Now, you know, to your point where the market's a little worried
and there is growing anxiety is around the direct lending portion
of private credit. That segment of the market has grown
substantially over the last decade. It was about [$]500 billion
or so 10 years ago. It's about [$]1.3 trillion right now.
Andrew Sheets: And this is lending directly to
companies?
Vishwas Patkar: Yeah. This is lending directly
to companies. Leverage typically tends to be higher than what you
see in the public market. So, one of the challenges around
navigating the risks are, you know, when you get a bunch of
negative headlines that isn't necessarily the readily available
information to either disprove or validate it.
So, I think that's some of the anxiety, which is building among
the investor base. Our view is, you know, these risks are
significant and investors should be cognizant of what's
happening.
Andrew Sheets: So maybe just to take a step back
a little bit there. Why have investors been more worried about
the private credit space?
Have we seen particular events? Or is it more, kind of, other
factors that you think have driven this increased focus?
Vishwas Patkar: Yeah, I think it's been a
rolling set of factors. This year the whole story has really been
about software and concerns about AI disruption. But before I get
into that, I think it was a process that really began, I would
say, second half of last year.
So, private credit really had its moment in the sun a few years
ago where inflows were massive. The public market was choppy
while the Fed was hiking rates, and a lot of stressed issuers
were choosing to raise capital via direct lenders. And at that
time, spreads in the private credit market were also very
attractive.
What you've seen last year is private credit AUM was effectively
flat. The fee income being generated on the loans has come down
as the Fed has eased policy and the spread on private credit
versus the public market has also narrowed. So, what started off,
I think, was more macro. It was driven more by what was happening
on the policy front…
Andrew Sheets: More yield compression. Less
yield for investors, which caused them to be just a little bit
less attracted to the space…
Vishwas Patkar: Absolutely, yeah. And I think
that was largely the driver of, you know, the correction in some
of these asset manager stocks to begin with. Then you had some of
the headlines around specific single name headlines. Double
pledging of collateral, some accounting malpractices, which, you
know, I think we can say with the benefit of hindsight, those
were idiosyncratic. Those were one offs. But again, you know,
doesn't make for a positive headline when you get news flow to
that effect.
And then this year, as I said, it's really been about concerns
around the software sector…
Andrew Sheets: Which is a very big part of the
private credit market.
Vishwas Patkar: It is a very big part of the
private credit market. It made up for almost a third of all LBOs
that were originated between 2018 through 2022. And in fact,
really if you look at 2021, when interest rates were very low, a
lot of the outstanding software loans were originated in those
really weak vintages.
And so, you know, I think AI disruption has maybe been the
catalyst to drive some of this price action. But that's on top of
software, where a lot of loans were originated with high
leverage. But now that, you know, you have a very disruptive
force around margins, potentially looming, the concern has now
shifted towards what do balance sheets look like. And the
software sector is very levered. In the bank loan market, for
example, more than 50 percent of software loans outstanding are
rated B- or lower.
And one extension of that is that, you know, you have a
non-trivial amount of debt that is maturing in the next few
years. So, through 2028, we see about [$]65 billion of software
loans maturing largely in that lower quality cohort.
So, you know, even before we get clarity around how AI will
diffuse and disrupt or will not disrupt these names, the issue is
really refinancing. In this period of uncertainty, will all these
software loans over the next 12 to 18 months – will they have the
capital to term out their maturities?
Andrew Sheets: So, Vishwas, maybe just in
closing, as you're going around and talking to credit investors
at the moment, what do you think are the two or three biggest,
kind of, high level takeaways and views that you're trying to get
across?
Vishwas Patkar: A few things I would say. So,
specifically on private credit, we are saying that, you know, I
think we are in for a period where returns might be subpar. It is
possible that private credit sees AUM growth that is sluggish,
maybe even down year-over-year this year. But we would not
conflate that with something that's systemic. And I think it's
very important to lay that out. But importantly, some of the
linkages to the banking system are through, you know, leverage
that is significantly lower in this cycle than what we've seen in
the past, say prior to the GFC. So that's one.
Second, I continue to think that the aspect of issuance being
very high and somewhat agnostic to macro conditions, that's been
validated so far. And when I look at what credit markets are
priced for, in aggregate, we think valuations are still too
tight. And that's not withstanding everything that's going on in
the Middle East.
You know, we clearly have a commodity price shock to navigate.
And that can have a feedback loop via what central banks will do.
And the U.S. consumer. But I would say just the convexity of
credit is very weak. If, let's say, we get a…
Andrew Sheets: Limited upside versus relative to
more downside…
Vishwas Patkar: Very limited upside. And
downside, if we get both a technical and a fundamental – and why
it is, is significant.
And the third thing I would say is it makes sense to own hedges
here. You know, again, hedges can be expensive, can lead to loss
of carry. But they can also be a very efficient way to protect
yourself. And if you look at this time last year in the lead up
to Liberation Day, credit had held up really well for the first,
say, five or six weeks of that sell off.
But then when it moved, it moved very quickly. And in some ways,
you know, if you; if investors were able to protect themselves
through that last leg of volatility, that effectively provided a
very good entry point to capture the rally that played out
thereafter.
Andrew Sheets: Vishwas. I think that's a great
thing to keep in mind. Thanks for taking the time to talk.
Vishwas Patkar: Alright. Thank you for having
me, Andrew.
Andrew Sheets: And thank you as always for your
time. If you find Thoughts on the Market useful, let us know by
leaving review wherever you listen. And also tell a friend or
colleague about us today.
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