Back to the future for defaults
It’s a given that private debt defaults will rise due to economic slowdown, but the question is by how much? A market comment from Christophe Fritsch, global head of alternative credit at AXA IM, suggests a return to long-term averages.

As some companies struggle with increased costs and the effects of monetary policy, Fritsch says a default rate of around 3 percent may be expected. This is the same as the US leveraged loan long-term default rate and slightly higher than the equivalent rate of 2.5 percent for European leveraged loans.

It is a case, as AXA IM suggests, of going “back to the old normal” after many years of historically low defaults against a backdrop of exceptionally low interest rates. “Companies with strong cashflows and the ability to pass on inflation should continue to fare well,” says Fritsch.

He adds that fears about the loan maturity wall are premature, with data from JPMorgan showing loan maturities peaking between 2025 and 2028.

Fritsch’s overall view is upbeat: “It may appear strange to find a head of asset class so optimistic after a tough 2022. But we are returning to an environment in which higher dispersion in markets provides an opportunity to deliver strong performance in selected asset classes.

Five reasons to keep the faith
Want a safe harbour in stormy seas? Private credit fits the description according to Sam Adams, a portfolio manager at SR Alternative Credit, in a comment on the asset class’s prospects in 2023. He identifies five reasons why private credit should be a top investor choice:

1. Hedge against inflation: With many investments being floating rate, private debt can provide a natural hedge against inflation and provide some of the highest yields in the fixed income world. These loans also tend to be structured with interest rate floors, protecting returns when inflation falls.

2. Reduced market correlation: Private credit is not subject to mark-to-market volatility and has a long tenor, which also cushions market effects. Moreover, asset-backed loans are normally collateralised with assets that are less subject to price volatility. Collateral top-up and reserve requirements provide further insulation against macro developments and market fluctuations.

3. Principal protection: Secured lenders can protect their principal investment against deterioration or loss, even in the case of borrower default. This contrasts with equity investments which, as demonstrated on the stock market over the past year, are fully exposed.

4. Tighter control over assets: Individually negotiated and tailored transactions allow lenders to adjust terms to take into account each borrower’s unique circumstances and the special features of each industry. This yields a close understanding of each borrower, promoting well-structured financial and other covenants, and stronger reporting.

5. Underserved market: Private credit offers investors attractive returns – typical coupons range from 7 to 15 percent – because borrowers are underserved. While private lending has grown substantially in the past 10 years, economic uncertainty and market turbulence will only stoke the need for more privately sourced credit, and this demand may increase returns.

Survey challenges notion of debt’s favoured status
Despite SR’s view (above) of private credit as a safe harbour for investors, a new survey from State Street suggests it’s the least favoured alternative asset class when it comes to new allocations from institutional investors.

State Street’s survey of 480 investors found that private equity was most attractive, with 63 percent of respondents anticipating making it their largest allocation over the next two years. Real estate and infrastructure are next in the pecking order, with 48 percent each, while private credit is the favoured choice for 43 percent.

“Our survey finds that three quarters of respondents believe tougher economic conditions will create discounted opportunities, but investors are likely to bide their time, as at least half feel valuations have not yet fully adjusted,” said Paul Fleming, head of the global alternatives segment for State Street.

Nearly half of investors (47 percent) said they had made changes to their due diligence processes as they put a laser-like focus on deal quality while 42 percent said they had set the bar higher in terms of baseline standards, thereby narrowing the universe of investments they would be prepared to consider.

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