Private credit stress test as higher rates squeeze borrowers

Higher-for-longer interest rates were once heralded as an attractive yield driver for private credit investors, but industry professionals say tighter monetary policy is becoming the sector’s next major stress point.

Global central banks are grappling with renewed inflation pressures, following the energy squeeze caused by the Middle East war, which is raising the prospect of further interest rate hikes.

That’s a problem for private credit, where debt is typically floating-rate — meaning debt-servicing costs for underlying borrowers in many portfolios are likely to stay higher, while lenders are forced to distinguish between temporary flexibility and deeper credit stress.

It comes as the $2 trillion private sector is already contending with ongoing redemption pressures in retail-focused business development companies, fears of an AI-driven ‘SaaSpocalypse’ upending software-heavy portfolios, and individual corporate blow-ups.

Anant Kumar, managing director, global investment strategist, head of U.S. credit research and portfolio manager at Benefit Street Partners, said the current private credit lending landscape was built on the assumption that the interest rates spike of 2022 and 2023 was a peak that would quickly decline.

“Three years later, borrowers are still paying near-peak coupons,” Kumar said. “In fact, the market is now pricing hikes, not cuts. Nobody underwrote for that.”

The latest minutes of the Federal Reserve’s rate-setting Federal Open Market Committee meeting under new chairman Kevin Warsh showed officials were split over the direction of rates, with the dot-plot grid tilting towards one rate hike this year.

Kumar said higher base rates typically help in the short term because yields rise. But if rates stay high for an extended period, more marginal borrowers can be squeezed by interest servicing costs.

“If rates go up from here, many levered companies won’t survive in their current capital structures. That doesn’t mean the businesses die. It means restructurings,” he told CNBC via email.

Pressure on borrowers is already showing up in the form of maturity extensions, payment-in-kind (PIK) interest, sponsor checks and covenant relief — “usually in that order”, Kumar said.

“One amendment is fine — that’s just private credit working as designed. But the fourth amendment on the same name is not a bridge to recovery, it’s deferral,” he explained.

Sunaina Sinha Haldea, global head of private capital advisory at Raymond James, said higher rates are not breaking private credit uniformly — but they are removing the margin for error.

“The issue is not floating-rate loans per se. The issue is floating-rate leverage on businesses that were underwritten…