Rate cuts on the horizon?
As the later stages of the credit cycle play out, investors are looking to understand the potential impacts that looming rate cuts and continued corporate deterioration could have on return expectations for private credit.
The first order impacts of a rate cut will first flow through to any floating rate or spread products. Managers will likely see a linear step down in any credit product with a benchmark and floating rate, such as direct corporate loans. While managers have sought to get ahead of this potential impact, typically by locking in wider spreads or interest rate floors, investors should expect floating rate investment returns to correlate to changes in benchmark rates. A potential second order impact might be felt in fixed rate products. As markets digest rate cuts (and rates rally), investors could potentially bid spreads tighter on fixed rate investments or see spread tightening leak from public to private credit, as investors look to lock in attractive returns.
Further, when looking at overall spreads across private credit, the rally across public corporate investment grade (IG) and high yield (HY) over the course of 2024 has to some extent leaked through to more trafficked areas of private credit, such as upper middle market direct lending. For instance, middle market lending spreads have gone from ~650bps to ~550bps at the high end over this year. However, more niche pockets of private credit have historically shown less correlation to broader interest rate changes and corporate credit, with more consistent spreads or fixed rate contractual return dynamics. Areas such as asset-based lending, asset-backed financing and lower middle market direct lending have seen limited spread compression. Additionally, asset-based lending and other niche strategies also typically benefit from being able to secure higher interest rate floors.
Similarly, upper middle market direct lending portfolio company fundamentals have to some extent followed the deteriorating credit performance seen in the syndicated loan market, where defaults have picked up to ~3.28% with severities in the low to mid-50s. However, more esoteric segments of private credit have shown significant resilience due to strong creditor protections / structuring and overcollateralization. Niche lending strategies (not corporate based) have generally experienced limited fundamental deterioration to date.
Though private credit returns and credit performance will have some correlation to broader rates and economic performance, the asset class appears better positioned than public IG and HY, given enhanced structuring and credit protection, as well as collateral where performance is generally uncorrelated to corporate credit.