Private credit in 2023: The benefits of a bear market?

As we head into 2023, we believe the downside mitigation characteristics of investment-grade private credit could be valuable, as the public market faces the possibility of continued volatility, a bond bear market, and even a recession. Crucially, rising rates also create an environment not seen in many years, where investors can potentially capture higher yields and incremental spread versus publics across the investment-grade spectrum.  

In this private credit outlook, we explore conditions in investment-grade private credit and go deeper on how today’s challenging overall market landscape could fuel opportunities for investors.

Current state of the investment-grade private credit market

The investment-grade private credit market remains as competitive as ever with oversubscriptions and allocations ongoing. We continue to see new entrants among US insurers, where investment-grade private credit represents a long-standing core asset class, as well as in non-US insurers. This includes increasingly varied insurer types across health, property and casualty, and reinsurers. In addition, we’re witnessing a variety of new sector entrants such as pension and alternative asset funds.

In our view, there were ongoing opportunities to invest at a premium to public fixed income alternatives throughout 2022. As we close out the year, investment-grade private credit issuance volumes remain near historic highs.

Notably, there has been an increase in cross-border activity as market dislocations persist, especially in Europe due to the Russia/Ukraine war and related economic uncertainty. We also expect to see more high-quality public issuers look to the private credit market as a funding source as a result of limited domestic market borrowing opportunities and as a means of reducing their execution risk and diversifying their funding.

But with all this activity taking place in such an uncertain economic environment, it is important to consider how investment-grade private credit has historically fared in challenging markets.

Private credit in times of turmoil

In good times, the investment-grade private credit market has historically exhibited a variety of positive attributes for investors. For example, relative to more liquid public alternatives, it has offered the potential for a pricing premium, favorable asset/liability matching characteristics, credit-protective structural aspects, and incremental diversification.

But we think challenging times, perhaps counterintuitively, may offer even better opportunities for private credit. Take the global financial crisis (GFC) as an example. In 2008 – 2009, private credit demonstrated resilience in a very stressed economic environment as protective structures such as financial covenants required prepayment or price and term renegotiation if issuers were unable to stay within prescribed levels. Private credit also offered the potential for opportunistic investments during the GFC as new issuers found the flexible, negotiated, and bespoke nature of the asset class to be supportive and were willing to pay a premium to access financing.

This market resilience was illustrated again during the European banking crisis in 2010 – 2012 and, most recently, in 2020 – 2021 during the COVID-19 pandemic. In this latter case, issuance reached record levels and the market offered strong relative-value, highly negotiated credit protections (due to market dislocations), and access to public market and cross-border issuers at attractive spreads.

Given the potential for elevated volatility and a recession in 2023, we think private credit could once again offer incremental relative-value opportunities, in addition to its credit-protective attributes and diversification versus comparable public alternatives. Specifically, we expect investment-grade private credit to see incremental issuance opportunities and increased deal flow, fueling greater diversity in names, sectors, and geographies. In our view, this could provide investors with alpha-generating opportunities and attractive access across diversified public, private, and cross-border issuers at a premium.

Potential risks to private credit in 2023

Importantly, the private credit opportunity set also faces risks in today’s environment. In particular, a significantly deeper and longer recession could impact corporate earnings and affect a company’s ability to pay back its debt. Similarly, considerably higher or stickier inflation could drive rates higher for longer, which could have a short-term price impact on liquid fixed-rate bonds. Notably, this may be less of a concern to buy and hold private credit investors.

Though these environments do offer investors the ability to capitalize on wider spreads, this opportunity does come with potential risks. However, the investment-grade profile, higher position in the capital structure, and protective covenants can help mitigate these risks.

Bottom line on investing in private credit

Volatile and uncertain markets have historically offered private credit investors opportunities to outperform. In 2023, we expect private credit investors to see greater diversification of names and the ability to negotiate favorable pricing/terms. In our view, the investment-grade private credit market is particularly compelling as investors now have access to increased yields and attractive spreads as issuers have adjusted to today’s higher-rate environment.