In September, we laid out a high conviction view on private credit. These are loans extended by an asset manager (rather than a bank) to corporate borrowers. We were especially enthusiastic about a subcategory of private credit, direct lending. J.P. Morgan Asset Management’s 2024 Long-Term Capital Market Assumptions (LTCMAs) suggested direct lending would likely deliver annual total returns in excess of 8.5% over the next decade; we continue to think performance can be higher in the coming year.¹

Last year’s performance was solid overall, with the Cliffwater Direct Lending Index² clocking a total return of 12% in 2023. Yet there has been a steady drip of negative headlines about the space. Skeptics worry that investors may misjudge the balance of risk and reward in the fast-growing private credit sector.

We think those concerns are overstated. While there is risk of default and direct lending may not be appropriate for all investors, in this piece, we discuss the four reasons why we continue to have a constructive view on direct lending.

Direct lending yields still stand out

Recession fears have receded over the last six to nine months. Because investors are less concerned about a recession and an accompanying increase in loan defaults, public market credit spreads, which are the excess compensation investors receive for default risk, have fallen to historically low levels. High yield and investment grade spreads, for example, are trading at their tightest levels since 2010.

Leveraged (or syndicated) loans stand out in public corporate credit because they are still offering investors solid compensation. Leveraged loans are very similar to direct loans, with the notable difference that leveraged loans are tradeable securities and direct loans are not. We believe in exchange for less liquidity, direct lending offers investors 250 basis points of yield, per annum, above leverage loans.

Loan growth appears to be healthy, not bubble-esque

Direct lending has captured headlines as the fast-growing upstart of the leveraged finance world. Some investors worry growth is out of control, and that companies of questionable quality are taking on too much debt. We think the facts say otherwise.

The direct loan market is often cited to be $1.7 trillion in total loans outstanding. That would put it roughly on par with the more established U.S. high yield and leveraged loan markets, but that number is misleading for two reasons.

First, the $1.7 trillion estimate is global and includes loans originated outside of the U.S., whereas high yield and leveraged loans are U.S. only.

Second, the $1.7 trillion estimate includes a great deal of dry powder and other specialized strategies like distressed debt. Dry powder is capital that is invested with an asset manager, but is not yet lent out.

If we just focus on the U.S. and remove dry powder, we estimate outstanding direct loans in the U.S. to $475 billion, compared to total principal value of $925 billion for domestic high yield and $1.4 trillion for the USD Leveraged Loan Index (as of the second quarter of 2023).

The direct loan market is smaller than many assume.

It’s also important that, since 2010, leveraged financial debt has grown at the same pace as economy-wide nonfinancial corporate profits. This implies that the leveraged debt ecosystem has not grown too fast for the corporate sector. Instead, it has kept pace with the economy – and with companies’ ability to pay.

Within that ecosystem, direct lending has been taking market share from high yield and leveraged loans. Direct lending’s share of leveraged finance has grown to 17% as of the second quarter of 2023, from 7% in 2018.

Underwriting standards and fundamentals are solid

While lending standards have loosened a bit recently, suggesting lenders are not receiving as much compensation for a unit of risk and those standards remain still solid overall. Average net leverage for borrowers – a key financial health metric that compares net debt to earnings before interest, taxes, depreciation and amortization – has increased recently but remains well below 2021 and early 2022 levels.

Furthermore, risky "covenant lite” loans (which come with less protection for lenders) are not prevalent in direct lending deals. After analyzing a proprietary set of our J.P. Morgan Investment Bank data, we've found that only about 20% of direct lending deals completed during the last 12 months are covenant lite. By contrast, about 90% of syndicated loans are covenant lite.

Still, trends in the leveraged loan market may give us a clue about how fundamentals might be evolving for direct loan issuers. Overall, leverage loan fundamentals have fared better than we would have expected following the most aggressive Fed hiking cycle in decades.

For example, consider the median interest coverage ratio. It’s an important measurement of financial health that divides earnings by interest owed, and helps determine borrowers’ ability to pay. It’s fallen from recent highs of 2.6x in the first quarter of 2022, but stabilized in mid-2023 at levels below pre-COVID trends.³

Defaults may rise further. We think investors may be well compensated for the risk

Following the spike in borrowing rates over the past two years, defaults rose in public markets. However, they did so from extremely low levels. The increase only brought default rates back to their long-term median.

Investor credit losses are driven by default rates and by the recovery rate (the value of the assets in the event of default). Historically, credit losses in direct loans have tended to match losses in the high yield and leveraged loan markets.⁴ Realized losses in the Cliffwater Direct Lending Index measured 0.9% in 2023. That is consistent with about a 2% default rate using a 50% recovery rate.

Defaults are a fact of life in leveraged finance and it is possible defaults will increase further as debt costs rose following rate hikes by the Fed. Still, with we think investors may be well-compensated for that risk.

Bearing this in mind, we think that staying attuned to a couple of important pitfalls can help improve investors’ chances of success in this space.

What to watch out for:

• Concentration in direct lending loans originated in 2021/2022. We are especially concerned about the 2021/2022 vintage of loans, as they were underwritten with higher leverage and their terms may have been based on expectations for a lower interest rate environment.
• Asset managers that lack robust and transparent valuation processes. Because direct loans are private, their valuations may be written down more slowly than similar publicly traded products. This may translate to higher fees for investors compared to public market loans.

A recent private credit primer from the Federal Reserve cited KBRA data that showed loan valuations in direct lending, syndicated loans and high yield in the lead up to a default/recovery negotiation. Over the 12 months ending March 2024, only 17 borrowers in KBRA’s direct lending sample defaulted (or had implied recoveries),⁵ compared to 76 syndicated loan defaults and 37 defaults by high yield borrowers. The data showed direct lending valuations lagged those of syndicated loans and high yield in the lead up to default. However, it is critical to note that direct lending and syndicated loans had similar ending valuations, both above high yield bonds.

• Loan concentration in certain sectors. Per KBRA, more than one-third of direct loans are issued to software or health care companies. We preach diversification, and it’s critical here.

Investors remain skeptical of private credit, suggesting the asset class has grown too fast or looks too risky. We think those concerns are overstated.

Speak with your J.P. Morgan advisor to explore whether investing in private credit would support your long-term financial goals.