Navigating the Private Credit Landscape: Insights and Opportunities

Text on screen: Haydn Scott, Account Manager

Thanks for joining us and welcome to our latest private credit update.

Kyle, there are a huge amount of options available for investors in this space. What would your advice be to asset allocators in terms of differentiating between options, and what are some of the things that investors should be looking out for?

Text on screen: Kyle McCarthy, Alternative Credit Specialist

We have seen a lot of growth in private credit over the past few years. I think it's doubled in size since 2019, and a lot of that growth, we think is for pretty good reason.

There's a lot of benefits for end investors. You have consistent, stable cash flows and income. You have yields that are a bit above what you can get in the public markets, hence the illiquidity premium. There's a lot of defensive qualities and defensive characteristics being senior secured, sitting on top of the capital stack. And it offers a lot of diversification benefits to investors as well.

So you're right, I don't think the growth has been surprising by any means. I think as the asset class has matured in a lot of ways, and investors are warming up to the fact that private credit isn't just a monolith anymore – it's not just corporate direct lending, or it's not just property or commercial real estate-based lending, but it's including other things like asset-based lending as well, which is a big theme at PIMCO and an area that we've focused on for over a decade now.

We find a lot of value within that space. It offers additional diversification beyond just corporate direct lending and the property space, and is an area where, as we think  about the next phase and where this de-banking trend is occurring or where banks are retrenching or in retreat is in this asset-based lending space.

So whether it's consumer-related credit, whether it's mortgages, whether it's non-consumer or other forms of hard asset-backed lending like aviation finance for example, these are all areas where we're seeing significant amount of opportunity today.

Scott: One of the things we're talking to investors about more often is just around entry points. We're seeing the US potentially poised to achieve a soft landing. We're at the start of a rate cutting cycle. What would you say to folks looking to allocate capital in terms of entry point?

McCarthy: A lot of questions on interest rates today and even over the past couple of months we've seen quite a sizable shift in rates. There was a pretty material rally, at the end of the third quarter, leading up to the US election. Then we saw a pretty big reversal and rates have since sold off from then.

So there's a lot of questions on rate outlook, what does it mean for private credit more broadly. I think on one hand you have areas of private credit like corporate direct lending or even property-based lending that tends to be pure floating-rate exposure, so 100% floating.

I think we can all agree that the direction of interest rates is lower from here. Central banks are in cutting mode. We can all debate on the speed and the path. But I think the overall destination is pretty clear that rates are going to be coming down.

So if you're, again, only focused on purely floating rate, yes, yields will be lower going forward. I think that the key thing for investors to remember though is that rates are likely not going back to zero. So lower, but not zero. If rates fall by another 1%, two percentage points, we still think they're going to remain elevated and higher for longer.

And now post-election in the US, there's talk of rates having to remain higher for longer in more of a pro-growth, reflationary type environment. So we don't expect rates to come down to a level where they're going to be unattractive for investors.

I go back to my comments earlier on asset-based lending where this is a really unique space that blends not only floating-rate exposures but has a decent amount of fixed-rate assets in there as well. So as investors think about, again, diversifying their overall allocation to private credit with a lot of fixed-rate exposures in asset-based lending, it's a great complement for investors’ portfolios as we think about the tailwinds that that now brings going forward with rates likely to come down from here, this space will be a beneficiary of lower rates going forward.

Scott: How do you foresee things playing out if there, is indeed a hard landing and, or some kind of credit event?

McCarthy: Yes, it seems like the market has largely priced out a hard landing type scenario. But it is an important one to focus on. Even our base case is for more of a soft landing. And just using the US as an example we've been trending at about 3% GDP growth for the past year. That's north of the natural trend or potential GDP, as we call it, of only 2%. So we're growing above average.

That speaks to the resiliency of the US consumer and largely consumption. But that's largely priced in at the moment, right. Credit spreads in general are relatively tight across the board. So I think investors should be asking the question of if there is a growth hiccup or if growth slows, or we do get an unexpected recession, what does that mean for private credit?

And you're already seeing early signs of elevated rates biting for borrowers. Payment in kind or PIK as they call it, which is a forward indicator of potential stress going forward, is essentially when you take a loan and the interest, instead of being paid in cash, is added to the balance of the loan. So you're essentially kicking the can down the road in many cases, and you're starting to see that creep into more and more private credit portfolios.

So again, something to track not necessarily at alarming levels at the moment, but something, again, important for investors to keep on the radar.

So what else should they be focused on? Obviously manager selection is key, right. Looking at track record, look at history in the space, whether they have teams internally to work through restructurings and work through potential credit distressed assets.

The market really hasn't seen a real test in terms of distress cycle yet. So it is an important question for investors to be asking. And again, I would just encourage them to really think carefully about manager selection and ensuring they're partnering with someone with a lot of experience.

Scott: Thanks Kyle. Well, there you have it. We think the benefits of asset-based lending are fairly evident to see. We have structural seniority, we have resiliency of income, and we have diversity across the spectrum.

If you'd like any further information, please visit our website or get in contact with your PIMCO account manager. Thanks again and bye for now.