The Bank of England (BoE) has issued a warning about the risks posed by private credit and leveraged loans to financial stability in an environment of higher interest rates. Private debt, a market where Luxembourg structures play a major international role, looks “particularly vulnerable”.
In its latest Financial Stability report, the BoE underscored the challenges higher interest rates pose to the ability of companies in advanced economies to meet and refinance their debts.
The BoE’s concern is directed at risky corporate loans, such as those found in private credit and leveraged lending markets, which have experienced a notable increase over the past decade. These markets, the central bank warns, seem ‘particularly vulnerable’ to the current economic landscape.
A recent report on the Luxembourg private debt market by Alfi and KPMG shows that Luxembourg private debt funds have seen their assets under management grow by 51 percent to 404 billion euros. The global market, currently valued at 1,600 billion dollars, could, according to BlackRock, rise to 3,500 dollars by 2028.
The British central bank draws attention to a critical factor in determining creditworthiness for lenders — the ratio of a company’s profits to its interest payments. As interest rates climb, the BoE notes that it will become increasingly difficult for some businesses to refinance their debts, especially those that may have already faced diminished profits due to limited economic growth.
Although most market interest rates are now far below their respective peaks earlier this year, the Financial Stability report states, “While there are currently few signs of stress in these markets, a deteriorating macroeconomic outlook, for instance, could trigger sharp reassessments of credit risks.”
Substantial losses
Despite these concerns, the current outlook appears optimistic. Private debt has experienced substantial growth in recent years, reaching a global total of $1.6 trillion, a significant increase from $280 billion in 2007, according to data from PitchBook. BlackRock anticipates a further surge to $3.5 trillion within the next five years, while Moody’s Investors Service projects the asset class to reach $2 trillion by 2027.
This surge in private debt can be attributed to the retreat of commercial banks from lending, following regulatory changes post the Great Financial Crisis in 2008. This void in funding for smaller businesses and those with lower credit scores was filled by private equity giants such as KKR, Apollo, and Blackstone, operating with less oversight from regulatory authorities than traditional investment banks.
Private equity players, constituting almost half of private debt assets, employ various structures, including limited partnerships, limited liability companies, and business development companies (BDCs). The latter, unlike limited partnerships, are obligated to disclose financial data and to uphold specific capital thresholds for their loans.
The rest of the private-debt market, which includes mezzanine funds and special situation funds, have little to no regulatory oversight.
The new junk bonds
The current resurgence of interest in private debt draws parallels with the enthusiasm that surrounded junk bonds in the 1980s. These bonds, much like private debt today, offered high returns and were centered around companies deemed too risky by traditional investors. However, the historical precedent of the early 1990s, when the US experienced a recession and many companies struggled to meet significant debts, serves as a cautionary tale.
Moody’s Investor Service too warned that the onset of a recession, though seemingly less imminent now, could expose some of the weaker credits. A research report published in June stated that ‘higher interest rates, higher inflation, slower economic growth, and a contraction of valuation multiples’ could result in significant challenges. The credit rating agency singled out loans made in 2021 during the post-pandemic market frenzy as particularly risky.
Private debt
While long-term yields are likely to reach their peak around midyear, financing conditions are anticipated to remain tight in real terms in 2024. According to S&P Global Ratings’ credit outlook for 2024, borrowers have reduced near-term maturities, but the proportion of speculative-grade debt coming due sees a significant increase in 2025, making 2024 a pivotal year. Defaults are expected to rise further, reaching 5% in the U.S. and 3.75% in Europe, surpassing their long-term historical trends.
S&P Global Ratings anticipates additional credit deterioration in 2024, particularly at the lower end of the ratings scale, where close to 40% of credits are at risk of downgrades. Sectors exposed to a decline in consumer spending are deemed most vulnerable. Meanwhile, investment-grade credits are expected to generally maintain resilience, notwithstanding some margin compression, except for the real estate sector.
Earlier this year, S&P Global Ratings noted that regardless of the timing of a potential recession, a significantly large proportion of private credit issuers are at risk of default. The agency conducted stress tests on 2,000 private debt issuers using various scenarios, concluding that, under the mildest conditions, 54 percent would experience negative cash flows if the economy worsens. The research report emphasized, ‘We can expect a significant increase in defaults if interest rates remain high for an extended period.’
While such a scenario would present challenges for investors, it is unlikely to be catastrophic. Junk bonds weathered the collapse of the early 1990s and have since become an established asset class. Private debt, backed by many asset managers, may draw comfort from this historical resilience.