Our Chief Fixed Income Strategist Vishy Tirupattur and U.S. Head
of Credit Strategy Vishwas Patkar discuss the implications of
private credit’s exposure to the software industry.
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.
Vishwas Patkar: I'm Vishwas Patkar, Morgan
Stanley's U.S. Head of Credit Strategy.
Vishy Tirupattur: While potential
disruption from AI has been a key driver for markets [in the]
last few weeks, the focus of investor agenda has been in the
software sector. On today's podcast, we will talk about software
in the credit markets and its implications.
It's Monday, March 2nd at 10am in New York.
Vishwas, let's start by understanding how the exposure in
software manifests in the credit markets. How does it compare to
software, say, in the equity market?
Vishwas Patkar: Yeah, so the software
exposure in credit markets is large, and understandably that's
why investors are closely watching what's happening with software
in the equity market. But what's interesting and important for
investors to note is the exposure in credit is very different
from what it is in equities.
So, for instance, a good chunk of exposure in the credit market
is around private issuers. So, we estimate about 80 percent of
companies are private in the whole sample set that we looked at.
And that's largely a function of the fact that software is not a
big part of the more liquid spaces like Investment Grade and High
Yield. But it is heavily represented in the more opaque parts of
the market, like leveraged loans, CLOs, and, you know,
BDCs.
So, our analysis found that about 25 percent of BDC portfolios
are in software, closely followed by private credit CLOs. And
leveraged loan market was about 16 percent. So, that's an
important distinction to keep in mind versus the equity
market.
The second thing I would flag is – because the software sector
grew a lot in the loan market through the LBO wave of 2020 and
2021, it has a weaker credit quality skew to it than the overall
market. So about 50 percent of borrowers in the sector are rated
B - or lower. So, that's the lowest rungs of the rating
spectrum.
Many of these software deals were underwritten with higher
leverage than the broad market. And as a result of that you also
have more front-loaded maturities in the sector, which brings the
risks of refinancing, if some of this disruption persists.
But Vishy, that's a nice segue to you. Over the past couple of
years, you looked at the private credit market in depth and
that's where I think the exposure we found is the highest in
BDCs, you know, which is the public face of private credit. So,
in your assessment, what is the risk of software to private
credit, given all of the headlines that are popping up?
Vishy Tirupattur: Public face of private
credit – Vishwas, that's a great line.
BDCs – business development corporations for those who are not
familiar – are companies that invest in the debt of small and
medium sized companies, sourced through non-bank channels. BDCs
fund themselves through equity and debt issuance. So, if you look
at the portfolios of BDCs to look at their exposure to software,
there's a wide variation across the various BDC portfolios.
What makes the assessment of these software risks in BDCs
challenging is that many of these companies are private companies
without the reporting obligations of public companies. So, no
earnings reports, no 10-Ks or cues or broadly publicly available
financials look at.
So, in effect, these companies need to be re underwritten to
evaluate which of these companies would be disrupted from AI; and
which companies could actually benefit from AI and see their
margins expand. So, in the context of BDCs, liability spreads are
something we are watching closely. BDC liability spreads have
widened but we think more needs to happen there. The clearing
levels need to wait for the full resolution of the companies that
benefit and that get hurt by disruption that is still awaited.
So, we expect credit spreads of BDCs to remain volatile for some
time to come.
Vishwas Patkar: Okay. So, seems like this
is a significant, or at least a non-trivial risk factor for
credit markets, given the growth of the sector, leverage, the
skew and quality. But Vishy, do you think this could be systemic
for risk markets at large?
Vishy Tirupattur: So, I do think that this
is a significant risk, but I don't think it's a systemic risk.
The amount of leverage in BDC is fairly small. About 2x is the
kind of leverage. You compare that to the kind of leverage that
existed in the financial system before the financial crisis –
that’s orders of magnitude smaller risk. And also the linkage to
the banking system comes through the back leverage provided to
the non-bank lenders. But this leverage is substantially risk
remote with very high subordination levels. So, my conclusion
here is this is a significant risk but not a systemic risk.
So let me turn the same question to you, Vishwas. Taking on a
sort of historical perspective as well as a macro perspective,
how do you see this risk manifesting in the broader credit
space?
Vishwas Patkar: Yeah, so I would agree with
you Vishy, that we need to see a valuation reset. We think
spreads should go wider because of disruption concerns, even if
they affect a relatively narrow part of the market. But a lot of
that's happening against issuance that's rising. But I would say
the risk of systemic concerns really emerging is relatively low.
if you look at historical cycles where credit has been the weak
link in the economy, those are typically characterized by a lot
of corporate re-leveraging.
So, think about the late 1990s or from 2004 to 2007 or the early
2000-teens. These are all cycles where corporates were being very
aggressive, adding a lot of debt. And you know, when the economy
slowed, credit became the source of some default and downgrade
concerns.
We haven't really seen that type of credit cycle play out at all
in the past few years. If you look at corporate debt to GDP, for
example, it's gone down each of the last five years. Balance
sheet corporate leverage has been flat or actually gone lower in
spots. M&A activity, which is usually a good indicator of
corporate aggressiveness, still remains below trend. So, I think
we have had a fairly restrained credit cycle where in place
fundamentals are quite strong. And that's why I think the
systemic contagion from any credit spread weakness, I think could
be relatively muted.
Vishy Tirupattur: So, the key takeaway from
us is that software and credit is a significant risk but is not
quite systemic risk.
Thanks for listening. If you enjoy the podcast, please leave us a
review wherever you listen and share Thoughts on the Market with
a friend or colleague today.
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