Risk-adjusted returns for private credit are likely to become ever-more attractive in the coming months if the widely-forecast US recession materialises.
The asset class is on the radar of asset managers due to favourable conditions such as spread widening, higher base rates and more conservative deal structures due to lower leverage, larger equity contributions and tighter loan documentation.
“Although we expect any recession to be mild, investors may want to prepare by allocating to asset classes that historically have been more insulated during recessionary environments and provide attractive returns in elevated inflation environments. Private credit is one of the few asset classes that has done both,” said Saira Malik, chief investment officer at Nuveen.
For example, after stable all-in yields for private credit per unit of leverage from 2015 to 2021, the US fund house has seen these yields climb quickly over the past two years – with the ratio more than doubling from 140bp to 300bp.
Further, Barings is seeing all-in yields in the 10% to 12% range for senior “down the middle” deals with lower leverage and first-lien risk.
“From a historical basis, the risk-return on offer looks extremely attractive today,” added Ian Fowler, the firm’s co-head of global private finance.
He believes these tailwinds suggest an attractive direct lending vintage in 2023 and 2024. “We are not surprised to see increasingly strong demand for investors to put capital to work in this space.”
Targeted private credit potential
A key potential driver of attractive risk-adjusted returns in private credit is consumer spending.
While this has remained strong so far in the US, Nuveen’s Malik believes it is a double-edged sword – if demand for labour outpaces supply, the subsequent upward pressure on average hourly earnings feeds the US Federal Reserve’s ongoing hawkishness and might weaken consumer momentum towards the end of 2023.
Yet any softening in consumer strength is expected to shift the focus of private credit away from cyclical areas that are closely tied to the consumer, such as retail and restaurants.
Instead, the business services sector is less exposed to discretionary spending. “Consulting firms that provide design support for infrastructure projects offer a compelling example,” said Malik. “Municipalities hire these companies to design and engineer facilities or systems that provide essential services, such as water treatment plants and roads.”
The US federal Infrastructure Investment and Jobs Act of 2021 is another tailwind, she added, having already reserved funds for these types of projects.
Another appealing opportunity within business services are companies that perform regular maintenance on HVAC systems, including replacing equipment when needed. “Homeowners need to maintain their air conditioning and heating units and are less likely to pull back their spending in this area, even if income or savings decline,” Malik explained.
Dealing with defaults
Amid the opportunities for private credit, investors also need to consider elevated risks of default.
According to Fowler at Barings, the higher returns that private debt enjoys, means higher interest costs for the borrowers and therefore greater pressure on margins and profitability. “These come after a year or two of elevated inflation and the supply chain challenges that followed Covid.”
He therefore expects to see an increase in defaults, although added that these are likely to impact more highly levered businesses and more cyclical industries. “Those [companies] who have built more aggressive portfolios in the recent post-Covid ‘good times’ may come to regret some of the excessive risks taken,” said Fowler.
This might lead to a bifurcation in terms of manager performance, with those more disciplined and conservative managers outperforming – in turn, being positive overall for the asset class.
“It will reaffirm the importance of discipline and caution in delivering the stable and defensive income that this asset class has become renowned for,” explained Fowler.
