Increasing concerns over hidden loan problems surfaces in recent analysis

Increasing concerns over hidden loan problems surfaces in recent analysis

In a recent shift, corporate bond spreads have tightened yet again, with single-B US corporates yielding roughly 3.4% more than US Treasuries - approximately 1.8% below the long-term average. This surprising development unfolds despite economic growth projections being revised downward and interest rates remaining remarkably high.

You might wonder if this is a sign that the credit cycle is turning? Not necessarily, according to Jason Thomas, Head of Global Research & Investment Strategy at The Carlyle Group. In fact, he suggests that tight single-B spreads are better explained by a phenomenon called "bifurcation" – the splitting of markets into distinct segments.

Thomas posits that the clearest evidence of bifurcation can be found in private or semi-private credit markets, where traditional default rates may appear low but have been inflated by "liability management exercises" or opportunistic debt restructurings. Such maneuvers have kept default rates low but cause concern, as they could signal a shift in the credit cycle.

Furthermore, while providing concrete data on the private credit market can be challenging, Thomas believes a similar dynamic is at play in direct lending. Default rates in direct lending may appear low, but creditors have begun converting struggling borrowers' cash-pay coupons into payment-in-kind (PIK), where interest accrues to the principal balance.

PIKs have been making headlines lately. And as S&P Global Ratings explains, when a borrower opts to preserve cash flow by making PIK payments, it may indicate an inability to meet cash interest demands.

Since late 2023, PIK loans have been on the rise, with S&P Global Ratings' estimates of the share of loans making PIK payments exceeding 10% in the third quarter of 2024. This number came down slightly in the following quarter, but S&P expects it to rebound over the rest of 2025. Their estimates are based on their analysis of 165 business development companies (BDCs), which serve as wrappers for diversified pools of private credit.

As we see in the chart below, the proportion of income accounted for by PIKs varies widely across these BDCs:

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Reports from Lincoln International, a global banking advisory firm that tracks the performance of private assets, reveal that by the end of Q125, around 11% of debt investments tracked featured some element of PIK interest, up from 7% in 2021. Six percent of deals had "bad PIK" attributes – where PIK interest had been added to loans that did not originally include PIK interest. These "bad PIKs" offer a potential proxy for a shadow default index, thanks in part to the fact that loan-to-value ratios for these deals increased from 49% at the investment's close to 86% in Q1.

So, what does all this mean? It's difficult to predict the exact course of events, but it's clear that PIKs are becoming more common in the world of private credit. Carlyle's Jason Thomas warns that as market participants come to terms with a new interest rate regime, generosity towards struggling borrowers may begin to wane, and default rates could rise as a result.

Of course, it's easy to simply pretend everything is fine and kick the PIK can further down the road. But as economic conditions become increasingly uncertain, it's worth keeping an eye on private credit markets, which could offer a valuable window into the health of the overall credit cycle.

Further Reading:- Is it PIK-up time for cash-strapped companies? (FTAV)

1. The tightening of corporate bond spreads, such as single-B US corporates yielding more than US Treasuries, has led to discussions about whether it signals a turn in the credit cycle.
2. Jason Thomas, Head of Global Research & Investment Strategy at The Carlyle Group, suggests that this can be better explained by a phenomenon called "bifurcation," which splits markets into distinct segments.
3. In private or semi-private credit markets, default rates may appear low due to "liability management exercises" or opportunistic debt restructurings, but they could indicate a shift in the credit cycle.
4. PIKs, payment-in-kind where interest accrues to the principal balance, have been on the rise since late 2023, and their estimates exceeded 10% in the third quarter of 2024, according to S&P Global Ratings.
5. As economic conditions become increasingly uncertain, it's worth monitoring private credit markets, like business development companies (BDCs), as they could serve as a valuable window into the health of the overall credit cycle and investment landscape.

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