Blurred Lines in Credit Markets
Ask a CIO #26
I’m wrapping up this week’s newsletter from Art Basel in Miami. It’s my first time attending, and I admittedly did not make it through the full fair. It’s a lot!
But the talent and creativity on display is incredible, even to my untrained and completely undiscerning eye. And the people watching is next level.
The contrast between art and finance is high, but I like to think the financial markets are also capable of great creativity. After all, there are a lot of dollars at stake for those that can successfully come up with novel solutions to better meet market demands.
This week’s question turns the attention back on private credit. For all the potential criticism levied at it, I think the asset class is expanding in no small part because the participants are innovative and solving real needs.
Private credit continues to be in the news a lot, and a large asset manager has been quoted saying that public and private credit will converge in the next several years. How is that possible, and what does that mean for investors? Isn’t the size of private credit already an issue?
Ah, yes. The CEO of a large asset management firm has stated in multiple interviews that he expects public and private credit markets to converge. For public and private credit to become virtually indistinguishable from one another, first in the investment grade corporate market, and eventually throughout fixed income markets (and maybe, many years later, even in public and private equity markets).
Stepping back for a moment, I think there are actually three separate issues tangled together in this question. The first is the growth of direct lending and the dominance of direct lending in discussions around private credit. The second is the expansion of what’s considered private credit into the investment grade fixed income market. The third is the liquidity, or lack thereof, in public fixed income markets.
Starting with the first point – the most widely recognized bucket of private credit is the direct lending market, which is typically a single firm providing private debt to a private company. This is the part of the private credit market that has been displacing and competing against the broadly syndicated loan (BSL) market, also known as bank debt.
There’s been ample discussion around the implications of the growth of direct lending. Much of the discussion centers around the size of the direct lending market and whether it poses some sort of systemic risk (generally speaking, I don’t think so). Another part of the discussion, which I find more convincing, is the concern that the growth of direct lending reduces potentially valuable data points for understanding the health of certain parts of the market.1
In other words, the inner workings and financial health of private companies is generally not publicly reported. However, when private companies issue publicly traded debt, that results in a set of disclosures to the market. And the ongoing trading of that debt provides additional information in the form of price signals. If the debt is trading at distressed prices (let’s say, below 70 cents on the dollar), the market is giving a clear signal about the perceived health of the company.
Therefore, the argument goes, if direct lending increasingly replaces publicly traded credit, then there will be more blind spots in the market. I agree this concern is real and valid.
As for the second point – private credit is expanding both definitionally and practically into investment grade fixed income. This is a newer phenomenon, and very much being pushed forward by the asset manager referenced in your question. Without commenting on the asset manager’s particular strategy, it’s remarkable that large, investment grade corporates are in fact executing deals that might in prior periods have been done as public bond issuances. It’s early days, but it says something to me that large companies with outstanding investment grade debt are choosing privately negotiated debt to solve their capital needs.
To the extent that private credit increasingly supplants publicly issued bonds and syndicated credit, I agree that the market could lose some visibility into the health of corporate borrowers. I don’t have a good answer for how that challenge gets resolved.
And on the final point – public fixed income markets are not as liquid as their name would suggest. This is a genuine challenge that is widely recognized among fund managers and institutional investors. After all, bonds are a much more varied lot than stocks.
Whereas the stocks of companies are uniform, perpetual, and easily traded on secondary market exchanges (all exchanges are secondary markets), company bonds can have various maturities, coupons, and values. This heterogeneous quality makes bonds much less suitable for secondary exchange trading, and so bonds typically trade over the counter through broker-dealers. It’s easy to take for granted the continuous and transparent price discovery that exists in the stock market. That doesn’t exist in the bond market.
As a corollary, liquidity is a given in stock markets. But when it comes to bonds, liquidity is there when you don’t need it and often gone when you need it most. Much has been written about this phenomenon, which occurred most recently and noticeably during the early days of Covid in March 2020.2 These air pockets have extended even to Treasury markets during periods of extreme stress.3
To sum up, yes, private credit is expanding. It encompasses both the direct lending that competes with BSLs and is moving in on the territory that has traditionally belonged to public fixed income. But private credit is gaining ground primarily because borrowers are choosing to take private capital. This dichotomy exists in no small part because private credit is offering a competitive product that potentially better serves borrower needs.
So will public and private credit really be interchangeable? From the borrower standpoint, I think increasingly yes – it’s already the case in direct lending vs BSL. From the investor standpoint, I’m less sure. Maybe? If liquidity is a primary distinction between public and private credit, then public fixed income in periods of stress won’t necessarily deliver. But I’m not convinced that this concern, while real, is necessarily going to shift the definition of fixed income that quickly.
That said, without debating whether capital markets should look different, I think it’s irrefutable that they do look different today versus pre-Global Financial Crisis, and the pace of change appears to be increasing. How investors choose to assess the ongoing risk/reward in credit markets is likely to change too. After all, investors can choose what they invest in, but they don’t determine what the investment universe looks like.
Thanks for joining, and as always, reach out at askacio@ivyinvest.co!
Until next week,
Wendy
The Bloomberg Odd Lots podcast had an interesting conversation around this issue of market blind spots resulting from the growth of direct lending. The September 2nd episode is ominously titled: The Black Hole of Private Credit That's Swallowing the Economy.
I’m not going to go down the rabbit hole of whether bond ETFs improve or exacerbate bond liquidity issues. Suffice it to say, the bond market is not nearly as liquid as the stock market, and that can at times lead to weird distortions.