Thoughts on the Market: Can Private Credit Weather Macro Risks?

Podcast Information:

• Title: Thoughts on the Market
• Host/Author: Morgan Stanley
• Description: Short, thoughtful and regular takes on recent events in the markets from a variety of perspectives and voices within Morgan Stanley.
• Episode: Can Private Credit Weather Macro Risks?
• Release Date: May 13, 2025

Introduction

In the May 13, 2025 episode of Thoughts on the Market, Morgan Stanley's Chief Fixed Income Strategist, Vishi Tirupatua, and US Leveraged Finance Strategist, Joyce Zhang, delve into the resilience of the private credit market amidst prevailing macroeconomic uncertainties. The discussion centers on whether private credit can sustain its performance in the face of heightened risks or if a market reckoning is imminent.

Current State of the Private Credit Market

Vishi Tirupatua opens the conversation by highlighting the current landscape of the private credit markets. “Will it stay resilient in the current macro conditions or a reckoning is ahead of us?” (00:09). The focus is particularly on direct lending and middle-market segments, where smaller companies with relatively weaker fundamentals are more vulnerable to economic slowdowns.

Joyce Zhang provides an initial assessment, acknowledging rising risks but emphasizing the resilience of the underlying fundamentals. “Risks are rising in private credit, but I think these risks would be measured given the still resilient fundamental backdrop,” she states (01:01). She notes that unlike previous cycles, there is no significant buildup of leverage within the system, as leverage ratios among direct lending companies have either improved or remained stable.

Risks in Private Credit

The discussion pivots to the specific risks faced by private credit markets. Joyce elaborates that although risks are increasing, they are being mitigated by the current strong fundamentals. “There is no clear sign of leverage building up in the system yet,” she explains, contrasting the present situation with past cycles where excessive corporate leverage led to downturns.

However, she cautions about potential impacts from higher tariffs, which could affect direct lending companies. “Higher tariffs... could have a significant impact on direct lending companies,” Joyce points out, setting the stage for Vishi’s analysis on tariffs.

Impact of Tariffs

Vishi assesses the direct and indirect effects of tariffs on the private credit sector. “We think it's likely [the direct impact of tariffs] to be muted,” he comments (01:50). He explains that direct lending loans are predominantly allocated to defensive and service-oriented sectors such as technology, business services, and healthcare, which constitute over half of the loans in typical Business Development Company (BDC) portfolios.

Despite the muted direct impact, Vishi warns of secondary effects stemming from increased uncertainty and diminished confidence, which could dampen demand. He references data indicating that approximately 15% of direct lending companies have an EBITDA interest coverage ratio below 1x (01:50), and about 40% are generating negative free operating cash flow (03:11). These "tail cohorts" are particularly vulnerable to macroeconomic challenges.

Payment in Kind (PIC) Interest Explained

The conversation shifts to the concept of Payment in Kind (PIC) interest, a critical factor in private credit dynamics. Joyce defines PIC interest as situations where companies under liquidity stress cease paying interest in cash, opting instead to accrue the interest to the principal balance. “It is quite common for companies under liquidity stress to switch to PICs for cash preservation,” she explains (03:11).

She highlights that while PICs can be a precursor to default, not all PIC loans indicate distress. “PIC toggles are actually a key feature that distinguishes direct lending loans from syndicated loans because it provides non-distressed companies the flexibility to reallocate cash for other business needs,” Joyce notes (03:11). Data from Business Development Companies (BDCs) show that higher peak income does not consistently correlate with increased non-accruals (04:19), suggesting that PICs do not universally signal rising defaults.

Structural Features Mitigating Risks

Vishi outlines several structural attributes of private credit that could help mitigate the identified risks. He notes that private credit loans are not marked to market by design, resulting in lower volatility and relative immunity from daily price fluctuations (04:19). Additionally, redemption risks are currently contained through mechanisms like lock-up periods and redemption caps, although their effectiveness in severe downturns remains untested.

Another mitigating factor is the “sticky” nature of capital flowing into private credit. Institutional investors such as insurance companies and pension funds, attracted by higher yields and illiquidity premiums, maintain long-term investment horizons and are more likely to support companies through temporary liquidity issues (04:19). Furthermore, the prevalence of small lender groups in the direct lending market facilitates easier negotiations during restructurings.

Default Rate Expectations

Joyce provides insights into expected default rates within the private credit sector. Referencing data from PitchBook, she notes the presence of substantial "dry powder"—$70 billion in private debt funds and an additional $2 trillion in private equity funds—that can be deployed to support distressed companies and help keep defaults in check (05:44).

She forecasts that syndicated loan defaults are expected to end the year at 4%, which, based on historical relationships, implies a like-for-like default rate for private credit at approximately 5% (05:44). This projection suggests a mild uptick from current levels but remains below the peak observed during the COVID-19 pandemic.

Conclusion

In summary, the episode underscores that while the private credit market faces rising risks amid macroeconomic uncertainties, several factors contribute to its resilience. Strong fundamental trends, structural safeguards, and ample available capital position private credit to navigate potential economic slowdowns effectively. Both Vishi Tirupatua and Joyce Zhang express cautious optimism, highlighting that although challenges exist, the private credit sector is well-equipped to manage and mitigate these risks.

Notable Quotes:

• Vishi Tirupatua (00:09): “Will it stay resilient in the current macro conditions or a reckoning is ahead of us?”
• Joyce Zhang (01:01): “Risks are rising in private credit, but I think these risks would be measured given the still resilient fundamental backdrop.”
• Vishi Tirupatua (01:50): “We think it's likely [the direct impact of tariffs] to be muted.”
• Joyce Zhang (03:11): “PIC toggles are actually a key feature that distinguishes direct lending loans from syndicated loans because it provides non-distressed companies the flexibility to reallocate cash for other business needs.”
• Vishi Tirupatua (04:19): “Direct lending loans are not mark to market by design, so they have lower volatility and are relatively immune from daily price moves.”
• Joyce Zhang (05:44): “There is ample dry powder... [which] can be deployed to backstop distressed companies and help keep defaults in check.”

Final Remarks

Vishi Tirupatua and Joyce Zhang conclude the episode by expressing gratitude to listeners and encouraging feedback on the podcast's content. They emphasize the importance of understanding the nuances of private credit in the current market environment and invite listeners to share their thoughts and insights.

This summary provides a comprehensive overview of the podcast episode, capturing all essential discussions, insights, and conclusions to inform those who have not listened to the original content.