Public Bonds Are Booming. Why Is Private Credit Flashing Distress?

Tricolor Holdings, a lender to individuals lacking credit, filed for Chapter 7 bankruptcy liquidation last month. Above, a Tricolor dealership in Houston. (Mark Felix/Bloomberg)

It’s two different worlds for income investors. In the markets for publicly traded corporate bonds, things couldn’t be better. Both investment-grade and speculative-grade securities are trading at historically slim yield margins over putatively riskless government debt. That translates into high relative prices for both quality and junk bonds.

But cracks are appearing in other parts of the credit sphere, notes Cliff Noreen, former head of global investment strategy at MassMutual: Notably, the markets for bank loans, private credit, and credit derivatives have shown symptoms of distress.

Bankruptcies have been the most apparent symptom, along with selloffs in publicly traded shares in companies participating in those sectors, such as business development companies and loan funds. Meanwhile, all of this has come amid a push for individuals’ retirement accounts to gain access to private credit.

In the public credit markets, these are boom times. Massive sales of new corporate bonds have been met with even bigger buying demand. U.S. investment-grade companies issued $207 billion in September, the fifth-biggest monthly tally on record, drawn by favorable financing conditions, according to Bloomberg. Those offerings often were oversubscribed many times over, Noreen says, helped by large inflows into exchange-traded funds.

Much of that demand reflects Federal Reserve interest-rate cuts, both the quarter-percentage-point reduction in September, plus expectations of two more such moves later this month and in December. Another two trims are priced in the federal-funds futures market by mid-2026, which would bring the target for the central bank’s key policy rate down to a range of 3% to 3.25%, a full percentage point below current levels.

While public bonds have rallied, with the iShares iBoxx $ Investment Grade Corporate Bond ETF returning 8.13% for the year through Oct. 1, according to Morningstar data, loans have done less well of late. For floating-rate bank loans, Fed rate cuts are seen as a negative since they would lower the loans’ interest payments.

Scott Carahar, head of senior loans at Nuveen, which has $28.7 billion of loans under management, insists it is a mistake for investors to turn their back on the asset class for that reason. He calls these loans, which typically are senior to other debt on borrowers’ balance sheets, a powerful diversifier for investor portfolios.

Even with the expected Fed rate cuts, loans that currently pay about 7% would drop to 6%, still an attractive return, he adds. So far this year, the firm’s main loan mutual fund, Nuveen Floating Rate Income, has returned 4.81%. Over the past 12 months, however, it returned 7.29%, versus the iShares corporate ETF’s 3.46% return.

But closed-end funds, or CEFs, that invest in senior loans have declined in price recently, notes David Tepper, who heads Tepper Capital Management, which specializes in CEF portfolios. Discounts on these funds’ net asset values have widened to about 8% from about 2% on average this year amid concerns that lower short-term rates might lead to lower payouts. He sees this as a buying opportunity in selected CEFs, including the Invesco Senior Income, Eaton Vance Senior Income, and Eaton Vance Senior Floating Rate funds.

Still, there have been rumbles elsewhere in credit, notably related to the automotive sector.

Last month, Tricolor Holdings, a lender to individuals lacking credit that was the focus of a 2022 Barron’s investigation over its lending practices, filed for Chapter 7 bankruptcy liquidation. Some major banks, including JPMorgan Chase and Fifth Third Bancorp, face exposure to Tricolor’s bankruptcy.

That was followed by the Chapter 11 bankruptcy of auto parts company First Brands, which had $6 billion of leveraged loans outstanding. Of that, some $2 billion was included in collateralized loan obligations, according to a report this past week by PitchBook.

CLOs are similar to the notorious collateralized mortgage obligations, or CMOs, which were at the center of the 2008-09 financial crisis. CLOs slice and dice loans into tranches, with the top tier getting paid off first and others getting paid in succession and yielding more. A big difference: CLOs’ credit losses have been rare, in contrast to CMOs, which took subprime mortgages and conjured them into AAA-rated tranches, with disastrous results.

The combination of safety and yield have made CLO ETFs popular with investors.

But Tepper notes that concerns over credit quality have crept into this sector. The Janus Henderson Aaa CLO ETF (which, as its name implies, invests in the top tier CLOs) has out-returned its higher-yielding but riskier stablemate, the Janus Henderson B-Bbb CLO ETF, 3.83% to 2.98% year to date.

In addition, business development companies—nonbank lenders to midsize business—also have come under pressure, as Barron’s Bill Alpert reported last month. The VanEck BDC Income ETF, which tracks the sector, posted a negative return of 6.75% in the latest month, bringing its year-to-date return to minus 5.24%. And that’s even with a cushion of 27% of the ETF’s portfolio in Treasury bills, according to Morningstar.

Amid these worrying signs, high-yield bonds have been consistently priced richly. According to calculations from Martin Fridson, the dean of speculative-grade debt and CEO of FridsonVision High Yield Strategy, the ICE BofA US High Yield Index’s spread has averaged 3.74 percentage points (versus comparable Treasuries) over the five years through Sept. 30. That compares with 5.21 percentage points for the five years ended Sept. 30, 2015, a period with no recession, which typically sends that spread out to 10 full percentage points, he wrote in an email.

Competition from private credit, which drew high-yield borrowers that previously would have tapped the public market, probably is a factor in tighter spreads in recent years, Fridson hypothesizes. The solution: Make private equity and private credit available to 401(k) holders, who have been cruelly deprived of the opportunity to earn great returns, he says sarcastically. That solves the problem of private-equity firms having difficulty in returning capital to limited partners—from a less sophisticated group of investors, he adds.

Income investors might be better off in the safer sectors of their familiar world of the public markets.

Write to Randall W. Forsyth at randall.forsyth@barrons.com