Rates Squeeze Puts Private Credit At Acute Risk

Authored by Simon White, Bloomberg macro strategist,

Private credit is entering a period of acute risk from higher rates induced by the energy shock.

The detente came, as many expected it would, with President Trump announcing talks between the US and Iran on ending hostilities. Yet with Iran continuing to fire missiles across the Middle East, the matter is unlikely to be at an end. Either way, markets will not remain unscathed from an energy shock that’s now sufficiently embedded to have a lasting effect on inflation and rates.

That poses a risk for private credit, which is fast becoming one of the biggest threats overhanging the market. The sector in the US has approximately doubled in five years to more than $1.2 trillion. But in recent months there has been slew of negative stories on deteriorating loan quality, large redemption requests, and the gating of investor monies.

A private-credit proxy I created based on the share prices of business development companies, or BDCs - among the largest traffickers in direct loans - and adjacent assets such as leveraged loans, shows a marked weakening in the asset class and a significant divergence from high-yield credit since last summer. With rates now rising across the globe, the risks have amplified further.

By design, private credit is opaque. A major selling point is that a lack of external scrutiny means that fund managers can hold loans through periods of stress. But while the loans themselves can’t be independently valued, the stocks of many BDCs can be.

Their recent weakening and divergence from listed credit demonstrates the market now demands a deeper discount to hold a non-transparent asset class with unobservable risks.

Private credit is supposed to be a portfolio diversifier, but during economic and financial shocks, correlations start to move toward one. Common drivers such as interest rates start to affect all assets similarly.

The shares of BDC firms have been increasingly moving together in recent months, in marked contrast to the stock market overall, where correlation still remains low.

Rising interest rates will only drive this trend further, indicating a heightened risk of a systemic blow-up in private credit.

The more you dig into it, the more private credit shows unwelcome parallels to the financial chicanery in the run up to the GFC. In a lacerating piece, Nick Nemeth, author of the Mispriced Assets Substack, itemizes the litany of red flags he sees in the private credit industry. He has done his own analysis, but it aligns with with existing work (I have cross-referenced his claims and added links).

Some of the lowlights he identified are:

• Loan funds are increasingly marketed to retail clients (Bloomberg)

• Loans are typically unitranche, especially to software firms - thus there is no loss absorption and every loss hits the fund dollar for dollar (IMF)

• Loans that are funded by insurers’ premiums, with the loans then going on the firms’ balance sheets (BIS)

• Increase in PIK (payment in kind) loan conversions (Bloomberg)

• Underreported loan default rates, with the actual rate probably much higher than the headline one (ABN)

• Unrealistically high Sharpe ratios (3-4, or more)

• Loan valuation agents paid by the funds they mark (SEC)

The last is one of the most egregious.

It’s worth pulling out the verbatim quote from the SEC in 2024:

“advisers have a conflict of interest with private funds ... when they value the fund’s assets and use that valuation as the basis for the calculation of the adviser’s fees and fund performance.”

That directly recalls the practice of mortgage appraisers compensated by lenders in the GFC.

We know how that ended.

It also explains the very high Sharpe ratios — the excess return an investment generates for each unit of risk — reported for some funds. Valuation agents who know what side their bread is buttered on are not incentivized to change loan marks. Steady returns plus negligible volatility produces credibility-defying Sharpe ratios.

Source: Cliffwater

High Sharpes are the proverbial turkey being fattened for Christmas.

The bird looks and feels better each day, until it all goes catastrophically wrong (for the bird). Likewise, stability breeds instability in markets, with monotonically increasing returns often presaging spectacular capitulations.

Stresses were building in private credit even before the Iran war: rising redemption requests and gating of investor withdrawals, as noted, as well as banks restricting some lending to funds and a notable drop in fundraising this year.

But they face another, potentially more acute danger from the rapid rise in rates sparked by skyrocketing energy prices.

After Monday’s apparent climb-down, the market is still pricing next to no rate cuts from the Federal Reserve this year, compared with more than 60 bps of reductions at the end of February.

Even if the Fed resists tightening, more restrictive financial conditions are on the way from higher yields and a tax on consumption from more expensive energy prices. This is not a good omen for credit, listed or private.

The private credit proxy’s one-year sensitivity to short-term US rates is now at its most negative for over two years, ie higher rates are bad for for the asset class. That’s in contrast to the market overall, which is still positively correlated with rates.

While private loans themselves are in theory immune from rising rates, lenders, borrowers and investors often won’t be. Lenders, for instance, have increasingly been relying on credit from banks, umbilically joining shadow finance with the conventional system.

Bank loans to non-bank financial institutions have ramped higher in the last one to two years, with more than $200 billion of obligations extended, according to the BIS. The Office of Financial Research comes to a higher estimate which includes borrowings to SPVs: $410-$540 billion of non-bank and bank exposures to private credit, with the bulk from the latter.

Source: Office of Financial Research

Borrowers might face strains from other interest-rate commitments, forcing loan terms to be renegotiated, further deteriorating the quality of the asset class. And as the OFC points out, during market shocks leveraged investors could be forced to liquidate unrelated assets, exacerbating volatility which could ultimately reverberate back to private loans as liquidity dries up in the secondary market.

Defenders of private credit would point to its safety features. The loans are typically senior-secured, overcollateralized and have lower refinancing risk due to long loan maturities.

But with an energy shock that’s becoming entrenched hitting inflation that was already recalcitrantly elevated, tighter financial conditions and higher yields are now likely baked in.

That may prove enough to tip a private credit market – already suffering from an erosion in loan quality and investor disquiet – over the edge.