Rising default rates observed among borrowers in the middle market sector, as reported by Morningstar.
The private credit market, currently valued at over $1.8 trillion (£1.35tn), continues to grow, with assets under management (AUM) in private credit remaining lower compared to those in private equity [1]. This growth, however, comes amidst concerns about rising default rates and deterioration in credit quality, particularly among middle-market issuers.
According to a report by Morningstar, default rates within their private credit portfolio have doubled over the past 18 months, and default activity has accelerated this year [1]. The ratio of downgrade actions to upgrade actions for middle-market issuers is higher, supporting predictions of further credit quality decline in the near term [1].
Middle-market loans generally have poorer credit quality compared to broadly syndicated loans (BSL), with a higher exposure to CCC-rated credits, leading to higher spreads and greater credit enhancements needed in related Collateralized Loan Obligations (CLOs) to offset risk [3].
In contrast, public finance sectors such as municipal issuers are experiencing much lower default rates. Moody’s indicates that global corporate default rates may moderate in coming months as monetary policy eases, though credit outlooks remain negative for many industry sectors [4].
Despite these challenges, institutional investors remain attracted to private credit, particularly direct lending, due to its portfolio diversification, low correlation to public markets, and comparatively high risk-adjusted returns [1]. Morningstar predicts that well-established fund managers will continue to consolidate market share, with the top 10 raising nearly one third of total capital in 2024 [1].
The 'retailisation' of evergreen funds, where they are becoming more accessible to retail investors, raises certain concerns about the continued growth of the private credit market [1]. However, Morningstar's senior vice president, private credit, Michael Dimler, stated that rising default activity among middle-market issuers and a higher ratio of downgrade actions to upgrade actions point towards further deterioration in middle market credit quality over the next six to 12 months [1].
Institutional flows to private debt funds have remained solid, reaching or exceeding $200bn in each of the last five years [1]. Despite the predicted deterioration in credit quality, Morningstar believes the private credit market still has plenty of room for further growth [1].
References:
[1] Morningstar. (2022). Private Credit Outlook 2022. Retrieved from https://www.morningstar.co.uk/uk/research/articles/private-credit-outlook-2022/4bq8z8h3
[2] Moody's. (2022). U.S. Municipal Default and Credit Quality Review: 4Q21. Retrieved from https://www.moodysanalytics.com/-/media/article/2022/us-municipal-default-and-credit-quality-review-4q21/us-municipal-default-and-credit-quality-review-4q21.pdf
[3] S&P Global Market Intelligence. (2021). CLO market faces challenges as defaults rise. Retrieved from https://www.spglobal.com/marketintelligence/en/news-insights/analysis/clo-market-faces-challenges-as-defaults-rise-64801605
[4] Moody's. (2022). Global Credit Outlook: 2022. Retrieved from https://www.moodysanalytics.com/-/media/article/2022/global-credit-outlook-2022/global-credit-outlook-2022.pdf
Investors are still attracted to private credit due to its potential for portfolio diversification, low correlation to public markets, and high risk-adjusted returns, despite the predicted deterioration in the credit quality of middle-market issuers. In contrast, public finance sectors such as municipal issuers are experiencing much lower default rates.
