The Federal Reserve raised the benchmark short-term interest rate by a quarter point last week, in the first interest rate hike since July 2023. As the Fed attempts to wrangle inflation back down towards 2%, markets are pricing in the likelihood of one, if not two more increases this year.
Higher short-term interest rates increase the cost of financing across markets, and private credit is no exception. For investors, this cuts both ways.
New investors in public or private debt will enjoy higher starting yields. Yields in public fixed income, such as treasuries or investment grade corporate bonds, are near their 15 year highs. Private credit has typically offered a premium of 150-200bps over similarly rated public debt, as compensation for giving up some liquidity.
Existing fixed income credit investors must contend with price impacts as well as yield effects. Rising rates can be punishing for bondholders, because existing fixed-rate bonds lose value as new bonds pay more. For investment grade bonds, for example, a 1% rise in interest rates translates to a total return of negative -0.8%, assuming a parallel shift in the yield curve. In 2022, the Bloomberg U.S. aggregate benchmark bond index returned -13% after 7 consecutive rate hikes.
When interest rate movements are on the horizon, many investors become concerned about price impacts, otherwise known as duration risk. This can make investors hesitant to own longer-dated bonds that pay higher returns.
Private credit is less sensitive to price impacts. Most direct lending is structured at floating rates. So coupon payments reset upwards as rates increase, and borrowers enjoy higher yields on existing debt.
Adding an allocation to private credit can help trim overall portfolio duration while preserving overall yield. It can be an effective complement to a fixed income portfolio and allow investors to access a more diverse set of credit opportunities.
Rate hikes are not without risk for private credit. The higher coupons must come from somewhere, and so private corporate borrowers must contend with larger interest bills. Unexpected hikes could leave some borrowers struggling to keep up on their interest payments or even put principal at risk.
These challenges are often not felt suddenly but can take time to work through. When interest rates rose rapidly in 2022, default rates did not spike significantly, and credit stress took longer to appear. Often, lenders and borrowers work things out before it comes to a default, whether by renegotiating the debt, swapping it for equity or pausing cash payments for a period.
As higher rates test weaker borrowers, the gap between managers can widen. Mangers who are successful across multiple rate cycles tend to be more selective about which deals to do, as well as more capable of managing problematic loans when stress emerges.
Higher rates are a double-edged sword for private credit. Floating rate coupons rise and duration risk stays low, but borrowers feel the squeeze. For longer-term investors who can tolerate illiquidity, private credit can complement a fixed income portfolio, but manager selection is paramount in a rising rate environment.