Sep 29, 2023

Bond quake sees doubling down on the shadows Mike Dolan The expanding shadows of private credit seem an odd place to lurk if central banks’ ‘higher-for-longer’ mantra on interest rates suggests they keep things tight until something breaks. And yet many asset managers are doubling down on the growing direct lending universe - assuming the higher returns in a “soft-landing” scenario for the world economy compensate for default or restructuring risks that are more manageable than in publicly-traded high-risk junk bonds. Screening out a lot of noise and holding your nerve in an inherently illiquid space seems to be a tall order. Right now, the noise is deafening and nerve is in short supply in the seemingly safest part of the debt market as longer-term government bonds that set base borrowing costs get whacked anew on rising uncertainty about where inflation and policy rates settle in the coming years and as debt piles rise. Without much change in near-term assumptions about peaking Federal Reserve policy rates, investors are starting to reprice long-term bonds to cope with a potentially more resilient, higher-inflation economy where the unwinding of central banks’ gigantic balance sheets of bonds also whips away market supports. Fed or European Central Bank policy rates may well be cresting now at last, but if they don’t come down again soon due to persistently above-target inflation - they could well start rising again from current levels if another cyclical expansion were to emerge without a recession ever occurring in this cycle. Debt supply projections and central bank balance sheet ‘normalization’ add to the angst. The result has been benchmark U.S. 10-year yields have spiraled almost a full percentage point higher to 16-year highs near 4.7% over the past quarter - with real, inflation-adjusted yields up 80 basis points to some 2.34%. The deeply inverted 2-to-10-year yield curve gap that many has assumed was a harbinger of recession is narrowing sharply. But perhaps the best indication of long-term uncertainty and a lack of visibility is the return of a so-called term premium - an often fuzzy measure of the added compensation in yield that investors demand for holding long-term bonds to maturity against rolling shorter-term paper over the same period. Bond analysts have differing models to measure this, but the New York Fed’s estimate turned positive this week for the first time in more than two years - having been in negative territory for all but two brief occasions in the past eight years. SHADOW PLAY And yet despite the government debt ructions and forecasts of gradually rising junk debt default rates close to 5% next year, the lack of an imminent recession has meant high-yield bond markets have remained relatively calm - with spreads over rising government yields still more than half a percentage point lower than the end of last year. The prospect of ‘higher-for-longer’ rates seems scary for fragile companies on floating-rate loans or who will be forced to refinance at much higher rates over that prolonged period - just as bank credit shrinks, lending standards tighten and bond markets gyrate. But at least public bond and leverage loan markets have visibility in pricing and offer some liquidity to get in or out. Many have long-feared the more opaque performance in private credit - direct lending by asset managers that Moody’s estimates has more than doubled in size since 2015 to some $1.5 trillion and which is now as big as the global junk bond market. With a lack of transparent data, especially in Europe, the sheer size of this debt pool hasn’t really been tested in a major downturn or period of prolonged high interest rates. And regulators have fretted about system risks - even if investors are typically pension, insurance and sovereign wealth funds that can better deal with illiquidity over long periods. Unfazed, BlackRock credit strategists this week said the growing private credit world was well priced and structured to weather the storm - and the illiquidity premia worth it even if the more active name selection and widening dispersion of performance was now inevitable. That the numbers of borrowers in that space may grow further as banks scale back lending is no surprise. But investment performance so far in this tightening cycle seems to stack up. Using a data set of 13,000 middle market loans totalling $284 billion embedded in the Cliffwater Direct Lending Index (CDLI), BlackRock showed realized loss rates from defaults or restructurings in the first half were 0.55% - compared to interest income of 5.63%. It also spotlighted data from the Lincoln International Senior Debt Index tracking 4,500 private borrowers that showed 425 loan terms were amended successfully in the first half of 2023 due largely to higher interest expenses. This meant loan covenant default rates actually fell during the second quarter. “This long-term relationship between lender and borrower can often result in a more efficient process for negotiating amendments versus what would otherwise occur in the syndicated public market,” the BlackRock team reckoned, adding this was on top of a 170-basis-point yield pickup on the CDLI over comparable leveraged loan indexes. Thierry Celestin, head of private assets at Lombard Odier, argues that, contrary to regulator concerns, the rise of private credit may actually lower systemic risks in a crisis by shifting the burden away from banks more vulnerable to short-term stress, dependent on deposits and subject to runs. “The illiquidity of private credit can be a barrier to some investors,” he concluded, but the high returns, low volatility and diversification involved works for those “with the appropriate risk tolerance, appetite and long-term time frame.” Shadowy or shining, the private credit world is set to face its first big test in a higher-for-longer world of unfolding bond market anxiety. Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today .