Private credit: attractive income and return potential in a ‘higher for longer’ world

While global interest rates raced higher last year, 2023 has been characterised by a cooler economic environment as central bank tightening slows and rates stabilise.

Experts from our direct lending, bank loans and distressed credit teams share their views on what’s next, and what this means for private credit investors.

In particular, they focus on:

• The market environment today
• What to look out for in the coming months

While Fed actions and guidance have caused some level of turbulence for public markets, they have meaningfully increased yields in direct lending. These are now at historically attractive levels of 12-13% on an unlevered basis.

At the same time, risks across the market have also evolved. Primary considerations for middle market borrowers continue to include: the impact of higher borrowing costs; labour and wage stress; higher raw material input costs; supply chain issues; and continued economic challenges and a potential recession.

These headwinds have the potential to increase default risk and, as such, we believe the winning managers will be those with the right investment strategy, asset selection and structure. We explore each of these factors in further detail below.
 

A defensive investment strategy

We employ a cycle-tested approach that is conservative and defensive. We target first lien, senior secured loans.¹ Furthermore, we focus on medium-sized companies in the core US market.² Importantly, our investments are structured with low loan-to-value, moderate leverage, and tightly constructed documentation with maintenance covenants. We are confident that this conservative approach is well suited to the current environment.
 

Choosing companies with a proven track record

While we believe macro conditions are likely to remain challenged, it is important to recognise that these are the market conditions where alpha can be generated. In these environments, we believe asset selection is paramount. We focus on companies with established track records of generating stable and consistent top-line revenue. Furthermore, we evaluate a company’s business against a comprehensive set of challenging baseline assumptions.
 

Reducing risk through conservative structuring

We believe the current environment is extremely conducive to executing conservatively structured transactions. Leverage levels on new transactions across the market have declined, while Loan-to Value (LTV) metrics have meaningfully improved. We have also been able to negotiate favorable call protection.³ Collectively, these conservative structuring elements allow us to meaningfully de-risk our investments.

As introduced previously, rates going forwards are expected to be higher for longer. However, a common question from investors remains, what happens when the economy ultimately starts to cool?

Once central banks pause rates, they are expected to stay at that level for quite some time and, when they ultimately fall, they are not expected to fall precipitously.

To help illustrate the opportunity, let’s look at a historical case study.

There have been four periods since the Global Financial Crisis when loan yields exceeded 8% (they are currently around 10% in US and 9% in Europe).

If you look at the ensuing 6-12 months, you will see that the loan market has delivered very strong outperformance over these periods, with a 10.69% average 12-month forward return.⁴

We believe this may present a compelling opportunity for long-term investors in bank loans and Collateralised Loan Obligations (CLOs) alike.
 

“Senior secured” status: attractive in times of turmoil

If the economy cools, you may expect to see defaults increase. However, in addition to their floating rate feature, the “senior secured” status of loans can help mitigate downside risk.

Historically, this has translated into relatively high recovery rates (60-70%) compared to other subordinated asset classes, for example high yield bonds (30-40%).⁵

This may prove particularly attractive for investors if we enter a recessionary environment.

Small companies often run into problems, regardless of economic conditions. This is one of the main reasons that we focus on them in our distressed credit and special situations portfolios. It creates an evergreen opportunity set and allows us exposure to companies across a diverse range of industry sectors.
 

Sizing the opportunity set

Importantly, today’s challenging economic backdrop is creating an even larger investment universe. What’s more, we believe that several tailwinds remain in place for our pipeline. The leveraged credit market, now roughly $6 trillion in size, is quite large on an absolute basis.

Even if we assume a modest default rate of 5% (approximately half of what occurred during the Global Financial Crisis), this would result in a materially larger distressed opportunity than any prior cycle.
 

Favourable maturity wall and issuance dynamics

Furthermore, almost half of the senior loans and high yield bonds maturing over the next 36 months are split B-rated. We will potentially see an increase in the number of distressed/downgraded company issuers, should the market environment deteriorate further.

Importantly for us, over 40% of these businesses have less than $500 million in debt outstanding. This means that they fall well within our small capitalisation target zone. Likewise, significant percentages (30-40%) of recent new issuance across these markets are similarly situated. In other words, they are either B3, B- or unrated, and issued by smaller companies.
 

The prevalence of CLOs

A period of significant downgrades could result in selling pressure for many original or “par” holders of this debt, particularly CLOs, which represent approximately 70% of the leveraged loan market and are limited in the amount of CCC-rated debt they can hold. Against this backdrop, we remain confident in our ability to identify good companies at attractive valuations.