New York. The US Federal Reserve (Fed) has implemented a change in interest rates this year, which could also shake up the market for private credit. In September, the monetary authorities led by Fed Chairman Kevin Warsh increased the key interest rate range for the first time in over three years. But even if the Fed paused on raising interest rates this week, the next increase is already looming at the end of the year.
The $2 trillion private credit market, also known as the “shadow banking sector,” actually benefits from higher interest rates in the market because it makes loans with variable interest rates. A higher interest rate promises higher income for investors.
And yet the share prices of the largest private credit houses slipped after the interest rate increase. At the beginning of the year, fears of over-indebted software companies in the portfolio, whose business models were threatened by AI development, had already caused unrest and sent prices plummeting.
Behind this is also the downside of the now rising interest rates: they increase the risk that companies will increasingly no longer be able to service their loan debts and could slip into bankruptcy. Default rates were already at a record level before the interest rate increase.
Karl Pettersen from the rating agency Scope warns that investors' continued appetite is masking the current risks: "We are still in a liquidity tsunami. And liquidity tends to obscure a lot of things." The first cracks can already be seen.
Credit expert Lotfi Karoui from the world's largest bond trader Pimco warns Handelsblatt that the higher interest rates will make refinancing difficult or even impossible for many companies with low creditworthiness under the current market conditions. The market is currently pricing in almost four rate hikes in the next twelve months.
“Most of these capital structures were built in a world where interest rates were much lower than they are today,” Karoui points out. “Therefore, there is no doubt that this is not good news for low credit loans.”
This is because the interest on private loans often consists of two parts. On the one hand, they consist of a fixed surcharge, which is based on the company's risk profile and can be between 4.0 and 8.0 percent, and on the other hand, of a variable base interest rate. This variable part is linked to the short-term reference interest rate SOFR (Secured Overnight Financing Rate), which is indirectly determined by the US Federal Reserve.
Karoui emphasizes that at the beginning of the year Private Credit focused primarily on concerns in the software sector. “In reality, the big shock came much earlier.” The expert sees this in the US Federal Reserve's aggressive interest rate tightening cycle in the wake of the pandemic between 2022 and 2023, when it raised its interest rates by 5.25 percentage points. According to Karoui, this immediately caused a payment shock for issuers. If another interest rate hike cycle is imminent, this could further accelerate the trend, the expert believes.
The situation on the market is already tense. According to the analysis firm Morningstar, almost 70 percent of borrowers in the market had interest coverage ratios of less than two at the end of June. That means they have limited room to absorb additional interest expenses when interest rates rise, Morningstar says.
James Charalambides from the US investment group Adams Street Partners highlights the company's own calculations to Handelsblatt, according to which around 7.5 percent of the total net asset value in the private credit market is attributable to companies whose ratios are even below one. “In other words, their interest expense is higher than their Ebitda.” And it can be assumed that this percentage will continue to rise due to the recent interest rate increase alone.
The interest coverage ratio shows how often a company can pay its interest from current earnings. The formula is: operating profit divided by interest expense. For example, a company achieves 100 million euros in EBIT and pays 50 million euros in interest. The quota is two. The result covers the interest twice.
According to Charalambides, interest rate increases are less of a problem for borrowers with conservative debt levels than for struggling sectors with high levels of debt. He sees the software industry, which has been extremely overheated in recent years and has high levels of debt, as particularly exposed. The fear of the greater use of artificial intelligence has led to a shortage of liquidity and the availability of outside capital. All this while growth has slowed and valuations have fallen.
Nonetheless, Pimco's Karoui points to a silver lining: the interest rate hikes are, in a sense, coming from a position of fundamental economic strength. “So I’m not too worried about high-quality companies.”
Daniel Leiter, head of Blackstone's international credit and insurance division, doesn't think the current interest rate increases are a big problem - as long as they stay within limits. Like Karoui, he also points to the drastic interest rate increases following the pandemic.
The companies that survived this period, he says, have prepared for higher interest rates - and have significantly improved their interest coverage ratios by a good 40 percent compared to previous years. "If you think about it, in 2022 there were suddenly three percent more interest rates - all at once. It's not as if the companies said: 'Interest rates are going down again.'"
The restructuring of the companies has already taken place, emphasizes Leiter. He believes that companies could cope with interest rates that are 0.5 to 1.0 percentage points higher. However, he certainly sees difficulties with larger, sudden interest rate hikes. "If interest rates rise by two or three percentage points from here, then we have another fundamental problem. But I think that's unlikely."
Looking back, even 2022 and 2023 were positive for the funds, says Leiter. With higher interest rates there is always a certain period of upheaval, but the positive effect in the form of higher returns outweighs the negative.
From the perspective of the US rating agency Moody's, it is not necessarily the higher interest rates that could become a problem, but rather the high number of refinancings that will soon take place in a higher interest rate environment. According to Moody’s, up to 37 percent of all loans will need to be refinanced between 2026 and 2028. In total, this could amount to around $40 billion in loans by 2028. “A further increase in interest rates would tighten refinancing conditions precisely when the debt accumulated in the previous financing environment comes due,” the rating agency said last month.
Added to this is the already high number of failures in the shadow banking sector. According to the US rating agency Fitch, the twelve-month default rate for private loans rose to 6.3 percent at the end of the third quarter. This is the highest rate recorded since Fitch began collecting the data. After the value had already risen to 6.3 percent in August, it remained at that level in September.
And depending on how the defaults are calculated in the market, which is considered notoriously opaque, this number is either significantly lower, at less than one percent, or it is even in double digits. The problem: There is currently no uniform definition for the question of what exactly constitutes a loan default in the private credit business. Karoui from Pimco used his own model for the calculation - and that puts the rate at 19 percent.
Karoui is based on how loan defaults are measured in the public market. Pimco therefore also includes the restructuring of non-performing loans or the use of subsequent “Payment-in-Kind” (PIK) payments in its stricter calculation.
The concept behind PIK: If the borrower can no longer pay the interest, it is added to the total debt. The fund records this as income even though no money is flowing in - for many critics a clear signal that the loan has long been groaning under the burden of debt.
Meanwhile, the common industry agreement, “amend and extend”, i.e. adjust the loan and extend the term, is derisively reinterpreted by critics as “amend and pretend”: adjust loan conditions and pretend that everything is fine.
Scope expert Pettersen also criticizes the practice: “The problem is simply pushed to an even less favorable time.”
"As borrowers become increasingly unable to pay interest, one would expect lenders to demand more compensation for taking on this risk. But instead they accept less compensation," economists at the Federal Reserve Bank of Boston wrote in August. The risk premiums (spreads) had fallen, even though PIK usage - a clear stress signal - had increased by 67 percent within the last three years.
However, they provided a possible explanation: Economists believe that increasing competition is responsible for the narrowing of spreads. And they dare to attempt another explanation: They even see the reduced risk premiums as an implicit form of restructuring. Accordingly, investors would voluntarily reduce the interest rate premium for companies in order to prevent the loan from defaulting.
From Pettersen's perspective, the problem is that demand from private credit investors in the market is still so high that there is more than enough liquidity available. “There is a cognitive dissonance between the risk that is observed and the way that risk is priced in,” says the expert. Many market participants tended to estimate the risk of this dissonance as zero because they did not systematically question the valuation process, says Pettersen.
We are now in the process of figuring out how to correctly assess and price the risk. If the gap between valuations and reality turns out to be too large in such a relevant market, the question will have to be asked at a social level at some point as to who will pay for it. Typically these are either private equity houses, the investors, says Pettersen – “or at some point the taxpayers”.
