The Big Idea
The run on the bank of private credit starts another lap
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The slow run on the bank of private credit continues as expected, at least based on the latest rounds of redemptions. Cliffwater’s $31 billion private credit fund saw 17% of shares ask for money back in the second quarter this year, up from 14% in the first quarter. And Blackstone’s $79 billion fund saw 10% of shares ask to redeem, a record for the fund. It is bad news for private debt funds and business development companies. But it is likely worse news for companies that rely on private credit for funding.
Private funds and BDCs only provide periodic information about portfolio performance, but some of the news lately shows performance slipping. Delinquencies in BDC loan portfolios jumped 43 bp in the first quarter to 2.12%, according to PitchBook, the largest quarterly jump and the highest delinquency rate in at least five years (Exhibit 1).
Exhibit 1: Loan delinquencies at business development companies rise
Source: PitchBook, Santander US Capital Markets
The state of private credit, nevertheless, is still fuzzy. The rates of delinquencies and distressed exchanges among loans in the Morningstar/LSTA leveraged loan index, for example, have been going down for most of the last year (Exhibit 2). Even though leveraged loans are not quite the same as private direct lending, both markets cater mainly to highly leveraged companies and the index numbers run counter to concerns that private credit is deteriorating. The signals are mixed.
Exhibit 2: But delinquencies and distressed exchanges in leveraged loans fall
Source: PitchBook, Santander US Capital Markets
That leaves shareholders in private debt funds and BDCs making decisions with conflicting signals and a relative lack of information. Confidentiality agreements often stop private debt funds from disclosing the financial condition of their borrowers and lack of independent secondary private loan trading precludes market signals . That leaves shareholders with the information conveyed by the action of their peers, who have started to run. Shareholders have incentives to run sooner rather than later to avoid getting stuck with only the loans the fund could not sell or borrow against.
Cliffwater and Blackstone and others have capped quarterly redemptions at 5% of NAV to avoid forced sales of assets. Other funds are adding to liquidity. Ares Strategic Income Fund on May 26, for example, boosted its $4.1 billion bank revolving credit facility by $850 million and extended maturity to May 2031. Fitch’s recent review of eight perpetually non-traded BDCs concluded they had enough liquidity to meet 5% quarterly redemptions through 2026.
Private debt funds and BDCs should have enough capital to survive a longer run. Recent work led by Gregor Matvos at Northwestern University reviewed most of the private debt fund industry. It found that most funds have equity equivalent to 65% to 80% of total assets. Debt is moderate and mainly reflects bank credit lines. And portfolios are spread across industries and geography. That does not mean limited partners get out without bumps and bruises. But private funds themselves do not look like systemic risks. They are far less leveraged than the average US bank.
Borrowers from private debt funds and BDCs look more vulnerable than the funds and BDCs themselves. If the run on funds and BDCs continues, which looks highly likely, then efforts to preserve liquidity should lead the funds and BDCs to pull back on direct lending. That could eventually leave their borrowers high and dry. Demand from existing BDC borrowers to roll their loans over looks set to ramp up into 2028, based on loan maturities (Exhibit 3). If the run continues that long, the drain on private debt market liquidity could leave some of those borrowers short. That’s when the slow run on the bank of private credit turns into a credit fundamental as more borrowers get forced to deleverage. The clock is slowly ticking.
Exhibit 3: BDC loan maturities suggest pressure to rollover ramps into 2028
Note: Data shows BDC holdings excluding equities, CLOs, other structured finance holdings.
Source: PitchBook, Santander US Capital Markets.
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The view in rates
The market for now has concluded that the Fed will start hiking within the next seven months, pushing rates up and flattening the yield curve. The very front end of the curve is probably stuck at a floor of 4.00% or higher through 2026 depending on US-Iran and expected short-term inflation. The 10-year note continues to look like it will spend more time above 4.40% than below it for the balance of the year. It would take a credible ceasefire in the Middle East and concrete steps toward a lasting agreement between the US and Iran for 10-year yields to drop below 4.40%.
Key market levels:
- Setting on 3-month term SOFR traded Friday at 365 bp
- Further out the curve, the 2-year note traded Friday at 4.16, up 16 bp over the week. The 10-year note traded at 4.55%, up 12 bp.
- The Treasury yield curve traded Friday with 2s10s at 38 bp, flatter by 5 bp over the last week, with 5s30s at 72 bp, flatter by 11 bp
- Breakeven 10-year inflation traded Friday at 236 bp, down 4 bp over the last week, with 5-year forward 5-year breakeven at 222 bp, down 1 bp and still signaling confidence that the Fed target still holds. The 10-year real rate finished the week at 218 bp, up 15 bp over the last week.
The view in spreads
The supply and demand balance looks constructive for MBS and a little less so for corporate debt. MBS net supply continues to run very low while Fannie Mae and Freddie Mac continue to add to their mortgage portfolios. Insurers continue to issue annuities and buy corporate and structured credit, but credit is facing significant needs to finance the current AI buildout. MBS spreads should be able to hold their ground in most circumstances, but credit spreads look soft depending on the volume of net issuance.
The Bloomberg US investment grade corporate bond index OAS traded on Friday at 72 bp, unchanged from last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 111 bp, wider by 2 bp in the last week. Par 30-year MBS TOAS closed Friday at 23 bp, wider by 3 bp in the last week.
The view in credit
Haves and have nots continue. Big companies have healthier balance sheets than smaller companies. Consumers at the middle-to-higher end of the income distribution also have liquidity and wealth. Bank lending to non-bank financial institutions, including private debt funds and business development companies continues to expand. Bank regulators continue to focus on that category of lending, which could eventually tighten the private credit markets. But for now, credit metrics for NBFI lending are strong relative to traditional bank lending such as C&I.
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