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Private credit has features that can help investors avoid the most dramatic levels of volatility in other asset classes, not least because as floating rate structures they are able to provide increasing income generation in a rising rate environment.
Direct lending facilities, for example, can be long dated and tightly covenanted in lenders’ favour, while senior secured loans enjoy the relative protection offered by their positioning at the very top of the capital structure.
This inherently conservative asset class has also positioned itself defensively heading into the volatility. While default rates across the sector are likely to increase over the coming year, these should be limited compared to public assets, and any pricing weakness is likely to be less severe than it was during the Global Financial Crisis (GFC).
Certain private credit products have always been resilient, with historically low default rates for collateralised loan obligations (CLOs) even in times of stress (no CLOs have defaulted since the GFC, and even before then the few defaults that did occur were mostly seen in BB-rated tranches). Meanwhile, current spread levels in the senior secured loan market suggest that a fair amount of bad news has already been priced in. Current valuations imply a one year forward default rate of 19.1 per cent, around twice the greatest ever default rate of 10.5 per cent experienced during the GFC. For context, Fitch has predicted a 3 per cent default rate in its base case for the upcoming volatility and 5 per cent in a more severe default scenario.
A market made of sterner stuff
Indeed, the European senior secured loan market is a fundamentally different beast now than it was going into the GFC. Back in January 2007, no deals were cov-lite, while some 97 per cent of the facilities in the market now have no covenants.
This naturally reduces the risk of defaults going into 2023 as companies won’t break covenants that don’t exist, allowing cyclical companies more room to navigate to the other side of the turmoil.
Similarly, interest coverage levels have strengthened over the last 15 years and now stand at around 3.9x compared to 2.7x in 2008, making the debt more affordable going into a potential recession. The proportion of CCC-rated facilities in the Western European Leveraged Loan Index has fallen to 4 per cent from 20 per cent heading into the GFC. That said, we believe the rating agencies may not continue the lenient approach to downgrades adopted over the pandemic.
More defences, but not immune
While we expect private markets to perform relatively well into 2023 there will be opportunities for investors to find assets at considerable discounts, though careful due diligence will be required to avoid value traps. The borrowers that access these markets operate in the real economy, facing sluggish consumer demand, rising rates, and market volatility. And although issuers are not under intense pressure to refinance existing deals - the maturity wall of senior secured facilities that needs to be replaced before 2024 is only €18 billion for example - there will be some names that are forced into amend-and-extend deals, or that may even default.
Although the recessionary backdrop will have an impact, we expect that many investors will benefit from a relatively calmer environment in the private credit markets compared to public ones. Given the volatility and balance of control shifting to lenders, we believe the next 12-24 months could create opportunities in the private credit space.
- Download the PDF of the 2023 Outlook to understand the latest thoughts of our investment teams as they position themselves for the polycrisis (and download the Asia Outlook here).
- Dig deeper into the data that's guiding their thinking: this deck provides context in charts.
- View the investment implications of the 2023 Outlook across different asset classes in this one-page matrix.