A string of large defaults in the auto sector have raised questions around quality across the credit spectrum. Investors are asking whether these troubled companies are “canaries in the coalmine” that could signal broader stresses in an interconnected credit ecosystem that now spans public as well as private credit.
What types of debt did the borrowers default on?
The most notable canaries to croak in September were First Brands, a privately held manufacturer of auto parts, and Tricolor, a provider of subprime auto loans. The companies had amassed billions of dollars of public and private debt of various forms, and became unable to repay their lenders.
It is important to first note that the majority of the recently troubled credit was not private credit, but rather leveraged loans. These are loans that are originated by banks and syndicated to institutional investors. They occupy a space between private and public credit: unlike corporate bonds, they are not registered under securities laws and not offered to individual investors, but they are priced and traded frequently among institutional investors.
In recent years, private wealth investors have gained some exposure to leveraged loans through Collateralized Loan Obligations (CLOs). CLOs buy up small slices of leveraged loans and tranche them into risk categories. Pools of AAA tranches, perceived as lower risk, have been marketed as below-investment grade securities, leading to easier accessibility by individuals.
If this sounds familiar, it might be because they bear a resemblance to collateralized debt obligations (CDOs), which exacerbated the 2008 global financial crisis. However, there are key distinctions. While the CDOs blamed for fueling the financial crisis were concentrated in a single macro factor (the housing market), CLOs generally span a diverse range of economic sectors. Investors have taken the recent defaults as a signal to examine sector exposure across portfolios in the backdrop of broader economic and tariff headwinds.
Could this trouble spill over to private credit?
As the popularity of private credit has grown, so too have critiques that some lenders have relaxed their lending standards in an effort to be competitive with banks and other lenders. Indeed, pockets of the market appear more risky, with weaker underwriting and an emphasis on speed rather than quality.
However, many lending platforms have remained disciplined, focusing on senior-secured lending and using limited leverage. Private credit has become a go-to source of lending for mid-sized companies with stable cash flows, and investment-grade private credit is a growing category.
Lending, whether it’s public or private, is all about managing downside risk. When evaluating credit investments, investors should carefully consider the risks inherent in a strategy, its degree of diversification, and the investment manager’s ability to evaluate risks as well as to recognize and actively manage them when challenges do emerge. For investors seeking greater diversification within private credit, consider allocating to areas such as private credit secondaries, distressed debt and special situations.
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