Asset-Based Finance Offers a Strategic Edge in Uncertain Markets

Alicia Li: Hello and welcome to our latest private credit update. Financial markets are experiencing a period of volatility and a shift in confidence, given the macro and geopolitical uncertainty. Kyle, what does this mean for private credit markets?

Kyle McCarthy: Heightened uncertainty is definitely back in the form of geopolitical uncertainty, trade policy, tariffs, et cetera, and it is playing out in terms of financial market volatility as well.

I think a key layer of defense that investors should be thinking about, is just diversification more broadly, and that applies specifically to your question on private credit as well. I would say that it’s a very broad universe, but we highly recommend investors to define it broadly and diversify even within private credit as well.

So, if I can start with impacts on the corporate direct lending space, this is a market that is very concentrated in a single sector, below investment grade companies, small to mid-sized, highly levered balance sheets. Clearly that will be susceptible to any economic downturn that we see going forward.

Asset-based lending as a diversifier, I think, should be top of mind for investors today. It adds a lot of diversification to corporate direct lending. The borrower base is highly diversified as we think about residential mortgages, student loans, consumer credit, aircraft leasing, equipment finance. So, that alone adds diversification. But, of course, the loan profiles themselves also pay down and de-risk over time. And then as the name “asset-backed” suggests, many of these loans are backed by hard, tangible assets that, again, provide an additional cushion or layer of support and downside protection.

So, we think if investors define private credit very broadly, they should really consider adding asset-based lending alongside corporate direct lending as a way to complement their current portfolios and a way to, again, to build in a bit more defense at a time of uncertainty.

Alicia Li: So, it sounds like we see better relative value in asset-based lending. Can you help us contrast it with the rest of the private credit market?

Kyle MCarthy: Yeah. From a relative value perspective, I would highlight two key elements. The first is competitive dynamics at play in the market today, and the second is the interest rate environment that we find ourselves in.

On the competitive side of things, we continue to observe within the corporate direct lending space, a still very heightened competitive environment. And what I mean by that is it's relatively crowded. There's been a lot of capital that has been raised over the past few years. Very limited deal flow currently with muted M&A [mergers and acquisitions] and LBO [leveraged buyout] activity.

And then you have the banks back as well. Banks are looking to take back market share, in the public syndicated market. And so, what that is doing to pricing is it's compressing spreads because of all that competition, and it means lower yields for investors. Contrast that with the asset-based lending side, and here, it’s very different because the banks are actually pulling back. This is where they're continuing to retrench, and that creates a much better environment in terms of valuations.

In addition, it's a much higher barriers to entry market. It requires a lot more underwriting specialisation with analytics. And in aggregate, again, much better relative value in our view, relative to corporate direct lending.

Now, the second component was on interest rates and here's where I think the asset-based lending market in general is really unique, in that the majority of it is actually fixed rate. So, as I think about the interest rate path going forward, likely more of a normalisation, interest rates likely coming down over the next couple of years, it provides a window for investors to invest today, lock in those high yields, but also build in some upside potential if rates were to decline further. Contrast that with corporate direct lending, which is 100% floating rate, and it wouldn't necessarily benefit from rates coming down.

So again, big picture, the two key trends I think to focus on going forward is the competitive environment where asset-based lending is much more favourable today relative to corporate direct lending. And then the interest rate path, which again, we think is a nice tailwind for the asset-backed space as well.

Alicia Li: So, Kyle, asset-based lending is a really dynamic market. How do we source for opportunities for investors?

Kyle McCarthy: Sourcing within asset-based usually comes in two main forms: either direct origination or secondary purchases. At PIMCO, we do both of those. We lean heavily on both channels. So, I frame it as more of a hybrid approach and capitalising on both.

In terms of direct origination, what we mean by that is often owning the origination platform, oftentimes through a joint venture. And I think this makes a lot of sense in certain markets. If there are long term secular growth trends that will benefit that space, if it has high barriers to entry, deep specialisation required, it can make a lot of sense to get that exclusive direct access through ownership. Aviation finance is a great example that comes to mind.

In other cases, though, you have secondary purchases. And these are basically partnerships that we set up with banks and non-bank originators, where they originate to sell. And that's how we get access to the underlying investments. And we do this across many different markets – student loans, mortgages, et cetera. It allows us to be very nimble, to apply a relative value lens across all these different markets, and we can lean into this massive growth engine that PIMCO has, which is our presence within the capital markets, our relationships with counterparties, with trading counterparties, banks globally. We have many, many channels that we can tap into to canvas the market for these types of opportunities.

So, in summary, on the sourcing side, we take a hybrid approach, a combination of both direct origination as well as secondary asset purchases.

Alicia Li: Thank you, Kyle. In navigating an environment where uncertainty is certain, we find better relative value in asset-based lending, given the more attractive and diversifying cash flow profiles.

If you're interested in finding out more information, please contact your PIMCO account manager. Thank you.