Navigating Private Credit Markets: Challenges and Opportunities

Text on screen: John Valtwies, Account Manager

Valtwies: Kyle, can you share with us PIMCO's latest views on private credit markets?

Text on screen: Kyle McCarthy, Alternative Credit Strategist

McCarthy: Sure. As a quick reminder, how we define private credit is four main credit verticals. You have corporate credit, commercial real estate debt, residential mortgages and specialty finance. Across those four areas, I would say we are most optimistic about the specialty finance area and the residential mortgage space. We're a bit more neutral on corporate credit, and are very cautious on commercial real estate debt. So we can unpack all of those in more detail.

The last point I would just say is in general, the environment remains very attractive today for private credit for three reasons: Yields are higher, spreads are wider. Two, leverage is lower, so LTVs are lower and documentation is tighter, meaning that covenant protections are much tighter as well. So from a risk-adjusted return perspective, we find the space in general quite attractive, but obviously our relative value views do vary a little bit sector by sector.

Valtwies: Obviously our lens is a global viewpoint. You touched on real estate. Can you touch on residential mortgage credits in more detail?

McCarthy: We still really like the residential mortgage space and it's primarily a supply-demand dynamic. Bottom line is, the market remains undersupplied relative to household formation. So in terms of credit fundamentals, they're still quite favourable. The consumer, particularly in the U.S., has also been very resilient, despite the credit tightening that we've seen. So overall, we like the credit fundamentals.

While we think house price appreciation is likely to slow going forward, we don't think that there's any major correction on the horizon. So we like the space from both the pricing perspective, as well as credit fundamentals perspective. And we're seeing lots of opportunities both in secondary sales from banks looking to reduce their footprint – so selling legacy pools of mortgages that they hold on balance sheet. And the new issue market is also quite attractive as well with borrowers putting down large down payments. And again, we like the space because you're secured by a single family, a physical home as well.

Valtwies: Commercial real estate has been grabbing a lot of headlines. Can you share with us your views on commercial real estate assets?

McCarthy: A very dynamic asset class at the moment. We think it's still in a period of transition and repricing. Clearly, all the headlines are around office and retail, where you are seeing headlines around defaults and a lot of potential stress on the horizon. And we do think that that will play out over a long period of time and is one of the main reasons why, again, we are cautious on commercial real estate debt.

Though I would also say it's important not to paint the entire industry with a single brushstroke. There are a lot of forms of commercial real estate that is still quite attractive and we think is still benefiting from a lot of tailwinds of growth and still increasing rents. So if you look at certain sectors like industrial, like multifamily or apartment complexes, in terms of the digital universe – so data centres, for example – student accommodation and anything more residential oriented, still very strong fundamentals.

So that is our primary focus at the moment, steering away from office and retail. But again, overall being very selective on the space despite yields being higher, leverage being lower, and covenants being tighter. All of that is still consistent within commercial real estate as well. It's just you have to be really selective by property type.

Valtwies: Now, corporate direct lending makes up the largest part of private credit markets. Can you share the outlook for the corporate sector?

McCarthy: Yes. So in the corporate space, I'd say it's very much a bifurcated opportunity set. So what I mean by that is the vintage of loans that were originated back in the peak of the market – so call it 2020, 2021, where it was easy money, spreads were low, yields were low, the assumption was rates would remain low for a long period of time – a lot of corporate borrowers maxed out the amount of leverage on balance sheets and did not hedge the interest rate risk associated with the floating rate loans.

So unfortunately, as we've seen, major credit tightening over the past 18 months, yields are up significantly, their borrowing costs are now up materially. So we do think that there may be some stress to play out within that cohort specifically.

Now, where it's bifurcated is the second cohort, which is new origination today, has all the characteristics and benefits I mentioned earlier of higher yields, wider spreads, better pricing, tighter covenants, lower leverage. The market has definitely repriced. And so we like new origination, any new loans that are being struck today or struck on cheaper valuations.

So that's kind of how we're approaching things, is a bit cautious on some of the legacy loans which may, again, that stress may play out over the next couple of years, but much more favourable view on new origination.

Valtwies: Specialty finance is an important part of the market as well. Can you share with us our latest views in that field?

McCarthy: This market is quite interesting because it is probably the market that is most impacted by the regional bank turmoil in the U.S. They're very active within consumer-oriented credit and other forms of asset-based lending. And so we view the specialty finance space as very similar to the corporate space, call it 10 years ago, when private lenders really stepped in and took market share there.

There's going to be significant growth, in our view, in specialty finance opportunities. So we are excited about that space in particular. And it is one of the areas that we, again, have a have a pretty favourable view on. There are really two main opportunities sets there. One, is consumer oriented. Specifically, we really like student loans and other forms of personal loans and consumer credit. Again, the U.S. consumer has been quite resilient in particular.

And second, more on the asset-based side, is aviation finance or aircraft leasing, where there's really strong growth fundamentals there. And we're very excited about that opportunity set as well.

So in summary, when you think about all these different sectors and we've spoken about all four credit verticals today, I think bottom line, private credit is a very attractive space right now, given where we are in the cycle. It offers higher yields, wider spreads, and what we're seeing on the public side, also offers investors that downside protection that they're looking for, given the many areas of uncertainty out there today. Senior secured in the capital stack, and is still very much diversifying, given how idiosyncratic it is. We talked about specialty finance, mortgages – these are all very high barriers to entry, difficult to access markets. And so those benefits to investors are very much alive and well today.

Valtwies: Well, thanks, Kyle. To learn more about private credit markets or the investment solutions we offer, please get in touch with your PIMCO account manager.