Episode Details

Our analysts Vishy Tirupattur and Joyce Jiang discuss the health of private credit as default pressures are building for borrowers amid weaker growth, fewer rate cuts and policy uncertainty.

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Vishy Tirupattur: Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley's Chief Fixed Income Strategist.

Joyce Jiang: And I'm Joyce Jiang, U.S. Leverage Finance Strategist.

Vishy Tirupattur: Today we'll take a look at private credit markets. Will it stay resilient in the current macro conditions? Or a reckoning is ahead of us.

It's Tuesday, May 13th at 10am in New York.

Tariffs and policy uncertainty are on the top of mind for people with an eye on the economy and markets. Certainly, a frequent topic of discussion for us on this podcast. In this environment, there has been growing concern about the health of corporate credit – and within corporate credit direct lending or middle market segments, where companies tend to be smaller in size and have weaker fundamentals are of particular concern. The business models of these companies are sensitive to slower growth.

Joyce, can you map out the risks associated with private credit companies?

Joyce Jiang: To your point, risks are rising in private credit, but I think these risks would be measured given the still resilient fundamental backdrop. Looking at fundamental trends, there is no clear sign of leverage building up in the system yet, and multiple data sources actually show that the leverage ratios among direct lending companies have either improved or remained flat. And that's very different from the previous cycles where excessive corporate leverage set the stage for the eventual downturn.

So, this time around credit, including both public credit and private credit, is not the source of the problem. But, of course, these direct lending companies would be impacted by higher tariffs. So, Vishy what's your view on the tariff impact?

Vishy Tirupattur: So, the direct impact of tariffs, Joyce, we think is likely to be muted. It's quite hard to quantify this exposure, but if you look at a number of different data sources, we find that the direct lending loans are more skewed towards defensive and service-oriented sectors.

For example, sectors such as a technology, business services and healthcare account for over half of the loans in typical BDC portfolios or Business Development Company portfolios of direct lending loans. But that said, even though the direct impact could be somewhat limited, there could be second order effects because there is higher uncertainty and weaker confidence, and that could weigh on demand. There could be a tail cohort that could be developing.

So, some data from Lincoln International, for example, shows that about 15 per cent of direct lending companies have EBITDA interest coverage ratio below 1x. Another way of looking at tail cohort is by looking at companies generating negative free operating cash flow. According to S&P data, that's about 40 per cent. These tail cohorts are stretched and are weakly positioned to weather macro challenges ahead.

So, Joyce, another thing that comes up frequently when we talk about private credit is Payment In Kind interest or the so-called PIK interest. Can you walk us through what is a PIK and why is it a concern?

Joyce Jiang: So, Payment In Kind interest – it occurs when the company stops paying interest in cash, but instead the interest is accrued and added to the principal balance. It is quite common for companies under liquidity stress to switch to PIKs for cash preservation, But in many c