Is Private Credit (PC) a bubble?
We do not see evidence of a bubble. Even with recent Federal Reserve interest rate cuts, PC loan yields are in the high single digits. In the typical corporate capital structure, the more risk you take, the higher the required return. However, PC loans could offer returns well in excess of where many economists project long-term equity returns to be. PC loans are senior and secured obligations of the borrower and are typically considered lower risk than unsecured bonds or equities. A substantial equity contribution from a private equity sponsor – often at 50% of the enterprise value of the business – provides substantial protection for the private credit investor.
We have seen record fundraising in the asset class and heightened competition among lenders. Many borrowers prefer PC borrowing to the more traditional broadly syndicated loans (BSL) or high yield bond options. It is a favorable time to borrow money if you’re a private equity-backed firm with favorable business prospects. Heightened lender competition positions our target asset classes for lower – but still favorable – returns in 2025. We believe lower future returns should be the expectation for investors across asset classes including equities, high yield bonds, and investment grade credit.
Loans going into CLOs must meet strict rating criteria from S&P Ratings Service or Moody’s. The loan rating criteria have remained largely unchanged since shortly after the financial crisis. Because CLOs are the largest buyers of leveraged loans, the loan ratings set a floor on the credit quality of what lenders can agree to.
PC loans are generally owned in long-term non-mark-to-market funds. The market should not see any forced selling of PC loans due to margin calls. The result is most likely stable loan pricing over time.
While declining spreads result in lower loan income, this usually happens in a market where losses on loans are expected to be moderate, as the economy is growing, and the credit markets are open for business.
How are lower spreads over the Secured Overnight Financing Rate (SOFR) affecting leveraged loans and CLOs?
How does the growth in CLO Exchange Traded Funds (ETFs) affect your business?
What is the outlook for CLO equity in an environment where defaults have been increasing?
I believe most CLO investors assume that 2% of the loans in CLOs will default each year. This can be thought of as a loan loss reserve. At year-end 2024, the JP Morgan Default Monitor had a default rate of 2.4%,1 in excess of the loan loss reserve. This is negative for CLO equity investors. However, recent default experience has been under 2%. While predicting default rates is challenging, a favorable economic backdrop and lower SOFR could be beneficial to corporate borrowers in 2025.
Loan recovery rates have been on a downward trend. I provided some detail on this in last year’s best questions piece.
Fortunately, during 2024 many CLOs were able to lower their financing costs and / or extend their reinvestment periods. These transactions increase cash flows to the equity and are not included in our normal base-case modeling assumptions. In many cases, the increase in fair market value that results from these transactions is material. CLO financing rates continued to improve at the beginning of 2025, making refinancings and extensions more accretive.
I am optimistic that the interplay of marginally higher loan losses and decreased financing costs could make for a profitable 2025 for CLO Equity.
What is the outlook for PC CLO BB Notes?
In our opinion, PC CLO BB Notes provide some of the best risk-adjusted returns we’ve seen. At year-end new-issue PC CLO BBs were issued with yields of 12.5%, and over the last thirty years have an annual default rate of 0.2%.2 We expect robust issuance of these securities in 2025 and additional yield compression.
These securities enable investors to get exposure to a diversified portfolio of PC loans with a distinctive benefit that losses on the loan portfolio are initially borne by the CLO’s equity investors. Therefore, we believe a PC CLO BB exposure is less risky than owning a loan portfolio directly and taking the first-loss risk on the loans.
PC CLO BBs, in our opinion, are robust, and current default rates – which have been increasing – would not pose a material risk to significant defaults in these securities.
Most PC CLO BBs today trade around par value, which limits the potential upside in these securities. Also, as the CLO’s non-call periods expire, the CLO’s equity investors will likely look to lower the financing costs of currently outstanding PC CLO BBs.
Have you seen an uptick in competition for PC CLO BBs and / or Equity?
We believe we are one of the largest diversified investors in PC CLO BBs and Equity. Our size and presence in the market allow us to drive deal terms and receive preferential allocations. We also work with CLO managers to bring their deals to market before an investment bank is engaged in the process. This enables us to create our deal flow rather than simply evaluating deals in the market.
We believe our Fund’s favorable returns have increased the competition for our target securities. The relative attractiveness of PC CLOs over BSL CLOs has been evident to us for over a decade, and many of today’s new investors are people we are partnering with on new transactions, as our Funds rarely take the entire available amount of our target securities.
How much Paid-in-Kind (PIK) interest is there in CLOs?
1 JP Morgan Default Rate Monitor January 2025
2 S&P Global Ratings 2024, assumes a five-year life
3 Morningstar LSTA Leveraged Loan Index
4 Palmer Square CLO AAA Index
5 Palmer Square CLO BB Index
6 Flat Rock Global estimate
