Direct lending returns will “more than offset” higher defaults this year
Direct lending strategies will produce another year of high returns that will more than offset a small rise in defaults, according to AllianceBernstein’s private credit executives.
Brent Humphries, president and founding member of AB Private Credit Investors and David Kuck, managing director of private credit product strategy at AB Private Alternatives Business Development, predicted that asset yields may be slightly lower this year but said there is still potential for high returns.
The private credit executives noted that the US Federal Reserve is expected to lower rates this year, but said they expect the pace of easing to be gradual due to the strength of the jobs market and above-target inflation.
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“The forward curve for the Secured Overnight Financing Rate (SOFR), the base rate used to price direct corporate loans, suggests the rate will decline to about 4.5 per cent by year-end, from above five per cent today,” the research said.
“But we expect it to stay well above the sub-one per cent levels that prevailed for more than a decade after the global financial crisis. Simply put: High base rates lead to high yields on loans, and that suggests higher return potential for direct lenders.”
They are predicting that average middle market direct lending yields will remain above 10 per cent this year, although this is down from 12.2 per cent in 2023.
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However, the analysis also forecast “a potential modest uptick in losses caused by borrowers struggling to meet increased debt service requirements” in a high-interest-rate environment.
It said that that higher rates would more than offset this, for lenders with scaled and diversified portfolios.
“For now, the economy remains resilient, and we think prospects are good for a soft landing,” the research said. “We also believe direct lending is well-positioned to withstand a modest recession. There may be pockets of stress and tighter liquidity for borrowers in select cases caused by higher rates. But we take comfort in the downside protection potential of senior secured loans executed at low loan-to-value ratios.”
Humphries’ and Kuck’s comments come after ratings agency Moody’s predicted earlier this week that returns could fall this year due to increased competition in the market.
“As rate hikes level and competition escalates, this will put pressure on private credit returns, including the generous illiquidity premiums that direct lenders wield over syndicated lenders in public markets,” said Christina Padgett, head of private credit research at Moody’s Investor Services.
