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Money Is Expensive But Credit Is Cheap

Worries that high interest rates would cause problems in the credit markets have so far been proven wrong. 

Although borrowing costs have skyrocketed for borrowers not locked-in to long-term fixed-rate financing, this is more than entirely due to the rise in risk-free yields on US Treasury yields and the interest rate controlled by the Federal Reserve.

As you’ll note, Treasury rates have gone up more than corporate bond yields. This would suggest that the US government’s cost to borrow at the market has been rising faster than companies trying to borrow in the corporate bond market. For example, the high-yield borrowing spread above Treasurys is cheaper than 90% of the instances, going back to the 1990s.

Similarly, the spread on investment-grade credit is trading near record-tights.

While money is expensive, credit is cheap.

That credit (credit spread above risk-free rate) has been inexpensive is inarguable — but has credit been available? If interest rates are at zero and reported credit spreads are low but no one is lending, what does it matter that the price of a theoretical loan you won’t get is cheap?

The question of credit availability — especially to cash-strapped firms — has been the concern of market participants. There appeared to be a siphoning of credit in three areas of leveraged finance as in 2023: the broadly syndicated loan (BSL) market, the high-yield bond market and the bank loan market.

In the leveraged loan market, which consists of broadly syndicated loans (BSL) made to sufficiently large borrowers where these loans can be traded between banks and non-bank investment firms like credit funds and collateralized loan obligations (CLOs), issuance retreated from the explosive high of 2021.

Issuance in the high-yield bond market ("junk bonds") fell sharply, and in the bank loan market, where banks make and retain loans (i.e. don’t sell them to non-banks), the growth of commercial and industrial (C&I) loans on bank balance sheets flatlined and actually declined.

A fall in issuance or origination can spell trouble if levered companies won’t be able to refinance their debt when it comes due. But what if the hole has been filled by a completely different asset class?

Enter private credit. This asset class has grown enormously even as other forms of leveraged finance have stagnated in popularity. While the amount of high-yield bonds is barely higher now than it was 10 years ago, private credit has roughly tripled in size over the same time period. 

While "private credit" is not new, a specific type of private credit — direct middle market lending — has grown even more: a whopping 600% since 2008.

Unlike banks, which make loans by crediting the borrower’s account with deposits (essentially printing money from nothing), direct lending takes money that already exists from institutional investors and makes direct loans at very high yields to companies too small to borrow in the bond or even leveraged loan market.

A little over 72% of this market is "sponsored," meaning private credit makes loans to companies fully- or partially-owned by private equity.

If this sounds circular, it is! Weighted by AUM, a whopping 81% of private credit funds are managed by firms that also manage private equity funds.

Who invests in private credit? Even the IMF struggled to pin down the exact figures in its new report, "The Rise And Risks of Private Credit." The usual folks — pension funds, asset managers, other private equity firms, family offices etc. — are involved but the IMF listed 30% and 35% of the investor base being identified as "Other" or "Unknown."

Also, at least 12% of the investors come from the insurance industry, including the life insurance industry, 16% of which is now owned by private equity firms (up from ~2% in 2011)!

It’s been said that private credit is increasingly being sold to individual investors through the wealth management channel, and that the product is something that’s increasingly "more sold than bought."

So yes, as many people smarter than I have pointed out, private credit has eaten the lunch of the high-yield bond and leveraged loan market, and is filling the gap left by the increasingly regulated banking sector. 

I think this is increasingly not just a story of who is getting the deals, but a macroeconomically significant phenomenon that can help explain why the US economy continues to perform so much better than expected.

― Jack Farley

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