Signs of distress are showing up in private credit
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Early warning signs are flashing in the private credit world.
Why it matters: The worries around private credit — loans made by non-banks typically to mid-size businesses — seem to have fallen off the front pages, but distress is building in this opaque market.
The latest: The private credit default rate rose to a record 6% through the second quarter, per data out late last month from Fitch Ratings.
- Separate research from the Federal Reserve Bank of Boston out this week finds a growing share of private credit borrowers are making what's known as payments-in-kind, or PIK. That means instead of paying creditors in cash, borrowers are rolling the interest into their loan balances.
- It's a sign that borrowers are low on funds.
Reality check: This doesn't mean a crisis is imminent, and Fitch's default rate includes both firms that filed for bankruptcies and those that deferred interest or extended their loan maturities under stress.
- That's exactly the kind of flexibility in loan terms that private credit boosters argue makes this a safer corner of the market than people believe.
- Still, the data suggests that part of the credit world is transitioning into a more difficult moment.
The big picture: Private credit has grown to a more than $1 trillion market. After the 2008 financial crisis, banks pulled back from lending to riskier borrowers.
- But it's a tough industry to examine. Most funds aren't required to disclose their holdings.
Zoom in: The Boston Fed looked at a more transparent slice of the market: business development companies, or BDCs, investment vehicles that have to report on their financials to the Securities and Exchange Commission.
- BDCs make up about 20% of the private credit market, says José Fillat, who co-authored the research. They provide loans to companies too big for traditional small-business loans and too small to tap public bond markets.
- The researchers analyzed BDC filings and found that payment-in-kind usage is increasing.
By the numbers: Since early 2022, the share of BDC loans using PIK rose to nearly 10% from nearly 6%.
- "It's a sign of stress," Fillat says.
- The increase in PIK usage is spread across industries — the stress isn't simply with one kind of firm, say, a result of the ailing software business.
Zoom out: You can blame a lot of this on the mechanics of higher interest rates. Most BDC loans have floating rates, so borrowers' interest bills rise when the Federal Reserve raises rates.
- Companies didn't have a problem making payments when the Fed was keeping rates near zero. Now, it's closer to 4%, and they're struggling.
State of play: Of course, rates have been higher for some time. But over the past year or so, small and mid-size businesses overall have been struggling under the weight of higher tariffs, as well as rising energy and commodity costs.
The intrigue: You'd think that the spread, or the additional amount of interest these borrowers must pay on top of the lending benchmark SOFR, would increase when borrowers become riskier.
- Instead, median BDC spreads narrowed by about 1 percentage point, the researchers find. That's likely because there's demand coming from investors.
- "There are many many players competing for the same deals," Fillat of the Boston Fed says.
Between the lines: That's a pretty uncomfortable combo — lenders are being paid less to take on more risk.
- That leaves investors more exposed if the economy stumbles.
The bottom line: Private credit isn't breaking, but it is bending, and the strain is getting harder to ignore.
