Key takeaways
- The market has priced in significant Fed rate cuts by mid-2025, which will reduce private credit’s yield. With inflation normalizing, however, real yields should remain attractive relative to history.
- In addition, lower rates should spur lending opportunities and alleviate pressure for weaker borrowers.
- We reject the notion that modestly lower rates are an outright negative for private credit investors.
Private credit performance has been a clear beneficiary of the Federal Reserve’s interest rate increases since early 2022. Returns for senior direct loans have been 12.5% over the past year, the highest on record save for the COVID recovery-induced performance of late 2020/early 2021. While the rate of change remains much debated following a 50bps initial rate cut in September, it is clear the Fed is set to reduce short-term rates further, inviting questions around the impacts on the floating-rate private credit market.
The return on private loans is broadly comprised of two parts: Yield and credit losses. Yields are comprised of three parts: The short-term risk-free rate—in the U.S., SOFR), a credit spread; and an original issue discount (“OID” – for example, lending $99 to receive back $100). In a vacuum, Fed rate cuts will reduce private credit yields in a one-to-one fashion. However, there are multiple factors that complicate the analysis of the impact of rate cuts.
First, investors should consider returns on a real—not nominal—basis. If the Fed reduces rates by 200bps by mid-2025 as the market expects, a private credit nominal yield of 9%–10% would likely imply a real yield of 7%–8%—higher than in 83% of cases throughout the market’s history.
Second, lower rates in the absence of a recession would likely spur a rebound in mergers and acquisitions (M&A) activity. Private equity deal flow has been sluggish for more than two years now, and while there have been signs of life recently, this has materially impacted the opportunity set for private lenders, increased competition and ultimately tightened lending spreads. Lower rates could catalyze deal flow, allowing private lenders to become more fully invested and potentially driving spreads modestly wider, both accretive to potential returns.
Finally, moderately lower rates would provide some much-needed relief to a select group of borrowers that need it. While default rates in private credit do not give reason for immediate concern, debt service coverage (the ratio of EBIDTA to debt service payments) has generally fallen from around 2.5x to 1.6x as the Fed has raised rates. Strong earnings growth has kept the ratio from falling to more concerning levels, but as the table below shows, even modest reductions in short-term rates would bring relief for borrowers.
In all, while rate cuts would likely reduce yields in the private credit market, we reject the notion that it would make the market less attractive for investors.
