Ed Altman Says Private Credit Has Broken a Junk Bond Barometer

(Bloomberg) -- The rise of private credit has had a surprising side effect: it’s made borrowing cheaper for companies in other high-yield markets, and has probably made a key barometer of credit risk less accurate, according to a professor who has spent decades studying junk and distressed debt.

The $1.6 trillion private credit market has brought a flood of capital to junk-rated companies, allowing them to borrow less in public markets than they might have otherwise. Since those corporations are selling less debt in public markets, junk bond valuations have surged, signaling there is little risk of delinquencies or defaults, according to Edward Altman, finance professor emeritus at New York University’s Stern School of Business. 

Valuations are often measured by spreads, or the extra yield that junk bonds pay relative to Treasuries. High-yield spreads have been narrowing this year, meaning those notes have grown comparatively more expensive and suggesting investors have little fear about those companies’ health. But Altman estimates that average junk bond spreads would be about 2 percentage points higher if not for factors including private credit.

“Private credit has been a relatively new competitor for more traditional leveraged finance,” Altman said. “Whenever there’s competition, there’s usually an impact on prices or, in this case, spreads.”

The average spread was 2.55 percentage points on Wednesday, but going back to 1986, that level has averaged closer to about 5.2 percentage points, according to Bloomberg index data. Current levels should be closer to historic levels, Altman told Bloomberg.

Investors don’t seem too worried now, but they probably should be, Altman said. Bankruptcy filings and leveraged loan defaults have climbed since 2022, and leverage levels are relatively high, Altman wrote in an analysis in August.

Altman, 83, has spent his career forecasting when defaults are coming. He developed the Z-score model for predicting bankruptcies for individual companies in 1968. It considers variables including measures of a company’s liquid assets relative to total assets, and retained earnings relative to assets.

Defaults have broadly been creeping higher for corporate debt since 2022. The default rate on junk bonds and leverage loans was about 5.2% in September, compared with 1.98% two years earlier, according to Moody’s Ratings.

Default rates for broadly syndicated loans have risen in part due to notable distressed debt exchanges, including McAfee’s former enterprise business restructuring $4.2 billion of leveraged loans in August. One of the largest so far has been Lumen Technologies Inc., which involved over $15 billion in outstanding debt, according to a Fitch note.

Assessing default rates for private credit is much more difficult, because lenders can quietly tweak the terms of a loan without the broader world knowing. That means the line between a refinancing and a distressed restructuring can be blurred. Less than 2% of private credit issuers had defaulted in 2024 as of October, said Eric Rosenthal, senior director at KBRA DLD.

It’s also unclear how private credit will fare in the next credit downturn, given how much it has grown in recent years.

The amount of assets under management in private credit has nearly doubled over roughly the last six years to $1.6 trillion as of the end of March, according to Preqin data. And companies that have used features known as payment-in-kind toggles to delay interest payments could find themselves struggling to refinance their debt.

“We haven’t had a major test in terms of a prolonged slow down in the economy and other pressures on the firms that borrow money in that market,” Altman said. “That could change and also the spreads could change due to a number of factors out there.”

Deals

Fundraising

Job Moves

Did You Miss?

--With assistance from Davide Scigliuzzo.

©2024 Bloomberg L.P.