Private credit may outperform public bonds as defaults rise

The opportunities for private credit may be expanding even as financial markets grow more turbulent and uncertain, according to Goldman Sachs Asset Management (GSAM).

Higher quality borrowers that may otherwise have issued debt in the public markets are seeking financing in private markets, attracted by certainty and speed of completing these transactions, Stephanie Rader, GSAM Global Head of Private Credit Client Solutions, and James Gelfer, in Portfolio Solutions for Alternatives Capital Markets and Strategy, write in a report. As interest rates climb, these loans are pricing at wider spreads (relative to similar-maturity high-yield bonds or leveraged loans) and higher overall yields, and they have more conservative capital structures.

And while they expect default rates to rise in the next few years, Rader and Gelfer project private debt to outperform public credit as more borrowers struggle to repay their obligations, owing to “selective sourcing, robust diligence, enhanced structure, direct access to the borrower and financials, and the ability to influence workout situations to maximize recovery value.”

There are signs that more borrowers may have a harder time repaying loans. Distress levels for high yield bond and leveraged loan markets have risen to about 9% as of the end of March, up from about 2% in 2022, according to Pitchbook/LCD data. At the same time, many private equity-backed borrowers face rising interest expense due to the floating-rate nature of much leveraged buyout (LBO) debt.

However, distress is defined by trading levels rather than fundamentals, and there have yet to be signs of widespread operational difficulties or business deterioration, according to GSAM. Default rates are still low in high yield and leveraged loans, as well as in private credit.

Overall, while the outlook for defaults in private credit may be more opaque than in high yield or leveraged loans, the category has a number of strengths, Rader and Gelfer write. Direct lending in private credit is oriented toward financial sponsors and transaction activity. Working with PE owners enables them to better navigate economic headwinds and benefit from additional capital infusions during times of distress, extending out the time it typically takes for loans backed by LBOs to reach default. During the depths of the pandemic, borrowers and lenders worked together and private credit posted a lower default rate than leveraged loans, according to the report.

One area the team is actively monitoring is how the impact of rising interest expenses associated with floating rate liabilities is affecting the most indebted borrowers. A borrower’s ability to continually service its debt load, as measured by interest coverage ratio, is the primary indicator of default risk — more useful than absolute debt levels, they write. Again, using leveraged loans as the test, because the data is available, borrowers with interest coverage of at least 3x have a long-term default rate around 2%. When interest coverage is in the 2x to 3x range, defaults rise to over 5%, and when coverage ratios fall below 2x, defaults spike to 11%.

This is particularly pertinent today, the authors caution, as rising interest expense combines with the pressure of upward trending input and labor costs that are becoming more difficult to pass along to customers. The interest coverage ratio for new leveraged loans is still around 3x, but there is wide variation among borrowers, and coverage ratios can change quickly.

At the same time, across debt markets, there are structural factors that have tended to push recovery rates lower in recent years. These include a lower cushion of subordinated debt to absorb losses and a higher concentration of covenant-lite loans.

But not all of this applies to private credit. The largest private credit deals may be covenant-lite, but middle market transactions often carry maintenance covenants that provide quicker recourse. A lack of syndication and tighter documentation means private credit lenders can come to the table more quickly in times of impending stress.

“In the private credit space,” Rader and Gelfer write, “the close nature of the borrower-lender relationship and embedded structural protections allow both sides to be proactive in addressing potential issues early in the process, leading to more selective defaults and workouts.”

While private credit has distinct advantages, these strengths aren’t always consistent across the entire market, Rader and Gelfer write, providing another reason why manager selection always is so vital. “We believe it is important to remember that the space is highly idiosyncratic with wide dispersion in positioning, as well as documentation and expertise, that can impact how different portfolios perform in down cycles.” 

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