Q&A: Credit Market Themes with Jim Vanek

The debate about the competition between private and public credit markets continues as headlines regularly attempt to site challenges emerging in private credit, particularly as retail clients gain access. This Q&A addresses this issue along with other key themes to consider when evaluating investment opportunities. 

Interest rate expectations have changed dramatically over the last few months, with less than two quarter-point cuts priced in for 2024, down from six at the start of the year. What does this ever-evolving interest rate outlook mean for the direct lending opportunity?

Expectations around interest rates – not just in terms of the number of cuts but also how they are expressed through swap rates – have been volatile since the Federal Reserve began its current interest rate hiking cycle two years ago. Over the past twelve months, five-year SOFR swap rates have moved within a range of 160 basis points, highlighting the uncertainty around the Fed’s future rate-setting path. What seems more certain, however, is that rates will remain elevated for an extended period, which has several implications for direct lenders. With short-dated base rates above 5% and five‑year SOFR swaps above 4% today, direct lending continues to represent a compelling total return opportunity. At the same time, although the solid macroeconomic data underpinning the current interest rate environment suggests a stronger underlying economy, it also means businesses borrowing on a floating-rate basis – or refinancing fixed‑rate high yield debt at higher coupons – are going to see more cashflow diverted toward interest expense. This in turn puts pressure on corporate fundamentals and potentially default rates. On top of that, a relentless inflationary environment is squeezing the margins of smaller companies that lack the bargaining power to negotiate with suppliers, and scale to raise prices for consumers. This speaks to the importance of prudent credit selection and underwriting.

There are close to $5.8 trillion of maturities across investment grade bonds, high yield debt and leveraged loans coming due in the next five years. What types of opportunities does this maturity wall open for Private Credit?

The opportunity to refinance debt originally placed in the public markets, particularly four‑to‑six years ago, is a growing theme in private credit. Given private structures can incorporate more flexible terms that address a borrower’s unique needs, we’ve seen an increase in demand for private solutions by companies that would have historically borrowed in public markets. Additionally, access to the syndicated high yield and leveraged loan markets is more susceptible to market and interest rate fluctuations versus private credit solutions, which are less vulnerable to market fluctuations.

What is your view on the dynamics of public versus private lending? How are issuers approaching the two options when they need to raise capital?

Issuers are increasingly approaching both the private and public markets for financing solutions to best address their needs. We believe that for credit markets to function at their best, both types of lending need to co-exist. We think the emergence of private credit as an alternative for large cap borrowers enhances the depth and durability of capital markets by offering issuers a variety of financing solutions, particularly as the banking system retrenches from some parts of the market. It’s also increasingly important for institutions in the leveraged finance market to offer both public and private solutions as many issuers are increasingly using a combination of both to finance themselves. In short, we see the increase in capital formation as a positive for the market overall.

What is your view on credit spreads in the public market versus the private market?

Corporate credit spreads in the public market have tightened considerably in the last six months to their tightest levels since the Global Financial Crisis. We’ve seen spreads in the private market trace tighter alongside those in the public market but importantly, the incremental spread available in private credit remains stable during this period of tightening – just as it did when rates began to rise in the first quarter of 2022. It’s this relationship and consistent availability of incremental spread we look to take advantage of in the private credit markets. Mapping the relationship over different market environments is a meaningful element of understanding the benefit of private investing strategies, alongside those historically available in the public markets.

What is your outlook for Private Credit for the rest of the year?

This period of higher interest rates has been marked by a substantial slowdown in M&A as the cost of credit has risen, impacting prospective equity returns and valuations. Though we’ve seen recent increases in corporate finance activity – such as higher refinancing activity in bond and loan markets and growing M&A deals this year – transaction volumes are still down compared to historical averages. This environment is likely to depress deployment despite substantial capital formation and demand for credit assets at prevailing yields. Additionally, we are seeing indications that default rates in both public and private markets are rising. This is unsurprising as rates have now been elevated for two years, which has increased interest expense burdens for floating-rate borrowers in an environment where inflationary pressure persists, but speaks to the importance of credit selection. Combined with our macroeconomic outlook,which sees rates higher for longer and a strong economy particularly in the U.S., we think the opportunity set to lend to bigger businesses on a first lien, senior secured basis at elevated yields remains attractive. We also believe that strong technicals lower the possibility of a material spread widening event in the near‑ and medium-term, absent an exogenous shock to the market.