The recent Milken conference was a masterclass in herd behavior, as the “masters of the universe” were asked about their investment preferences in today’s environment. There was near-unanimous consensus that private credit is the most attractive option.
The reason for this is straightforward. Most argue that banks have reduced lending due to deposit flight and a significant increase in the cost of capital. Additionally, Dodd-Frank regulations provide long-term tailwinds. However, amidst the promises of pristine underwriting and a golden era for the asset class, few discuss the specific financial factors at play.
Private credit primarily consists of floating rate loan instruments, although the discussion mostly revolves around corporate loans rather than asset-backed loans, which often come bundled at a fixed rate. But I digress.
In my opinion, a floating rate loan has two crucial factors, when aggregating some of the underlying sub-factors: long benchmark interest rates and short credit default rates. The goal is to have higher interest rates and lower defaults. Low interest rates reduce the gross yield of the floating rate loan, while high default rates erode the principal. Although credit spreads may compensate for higher defaults, it is reasonable to assume that during times of disruption, unexpected events lead to higher defaults than were previously anticipated.
Looking ahead, what can one expect from this asset class? Milken attendees promise “equity returns with fixed income risk.” As a side note, these attendees don’t seem to consider the tax burden of ordinary income in that comment. But again, I digress. A significant increase in interest rates, say 2% more, would result in substantial defaults. That seems fairly certain. Furthermore, it is unclear whether inflation would necessitate rates that high, at least based on today’s data, and there is uncertainty regarding whether the Fed has the stomach to raise rates to that extent.
There are at least two possible paths to lower rates: inflation could slow down due to higher rates via a mild recession, or there could be a severe recession. In a mild recession, we would see lower rates with slightly higher defaults, while in a severe recession, rates would be substantially lower with correspondingly high defaults. Both of these scenarios would be detrimental to private credit, as they would lower both the benchmark rate component of the gross yield and increase the default rate.
In my view, the best scenario for private credit is for nothing to change. Moderately elevated inflation would nominally increase earnings and reduce corporate leverage. Rates would remain moderately high, impacting equity layers but not significantly increasing defaults. A European credit fund CEO, who managed a portfolio of floating rate credit during the global financial crisis, mentioned (I cannot find the exact quote) that his worst year of returns was in 2009 not due to defaults in his portfolio, but because benchmark rates cliff-dove to zero.
However, everything in the market indicates lower rates in the future, despite the near-unanimous sentiment at the Milken conference that inflation will persist at higher levels. In such a scenario of lower rates, forward private credit returns may deteriorate, and one might wish for greater stickiness in the gross yield.
So, what can one do in this situation? Personally, I believe that locking in duration at higher yields is worth considering instead of investing new funds in floating rate instruments. This does not necessarily mean duration in fixed income; it could involve owning equity on the cheap that generates cash. In a world where rates gradually decline over time, we may find ourselves nostalgically longing for the yields of the past.