High interest rates and low defaults? A 2025 private credit outlook

Navigating the macro uncertainty 

The global macro picture had been improving in the second half of 2024, with robust growth in the US, stimulus in China, falling inflation and monetary easing from the Federal Reserve and the European Central Bank. November’s US presidential election result, however, has added more uncertainty to 2025, in our view, with potential disruptions to trade, immigration and geopolitics.  

What does this mean for private credit? We think it’s potentially a double-edged sword. Potential tax cuts and deregulation may boost economic growth and dealmaking in the US – a tailwind for transaction volume and credit quality. Extreme trade policies, however, could have severe knock-on implications for the rest of the world while also weakening the medium-term US macro picture.  

It could be months until we have more clarity. In the meantime, central banks are expected to continue cutting interest rates and corporate fundamentals remain healthy. Our base case, therefore, remains that there’ll be supportive market conditions in 2025.  

Despite recent cuts, interest rates are still relatively high compared to the last 10 years and are not expected to fall back to pandemic-level lows. All-in yield still looks attractive in our view (about 5-8% for investment grade [IG], 8-12+% for sub-investment grade [sub-IG] debt). Bouts of volatility are possible, but these could generate attractive investment opportunities for private credit (as we witnessed in 2022 and 2023) and demonstrate the value of robust structural protections. 

Nevertheless, we think it is important to keep focusing on fundamentals and stress-test against different scenarios. Assets with highly predictable cashflows, long-term contracts with strong counterparties and regulatory/secular support should perform well. Resilience against inflation will remain important, in our view. 

Finding value in a competitive market 

Private credit had a very busy 2024 across IG and sub-IG, and we think the market will continue to be busy in 2025. Issuance volume grew notably year-on-year, with many transactions underpinned by the transition towards decarbonisation and digitalisation – what we consider to be two key megatrends.  

The market was highly competitive in 2024, with all lender types actively deploying capital. A resurgence in bank lending increased competition in both IG and sub-IG. We’ve noted that the pressure has been particularly acute in direct lending, contributing to the c.100bps spread compression over the last 12 months[1].   

We think there is more upside risk for new issuance spreads in 2025, given the extent of compression last year, risk of market volatility and an expected increase in corporate finance activity. This could be offset by deregulation in the US, which may increase banks’ lending appetite.  

We believe private credit lenders will therefore need to keep working hard to generate attractive premium without comprising credit quality, rather than simply moving up the risk curve in search for yield. This means scouring a broader investment opportunity set and developing strong networks. For example, our approach involves targeting specific borrowers with identified needs and proactively engaging with them to find lending solutions. 

Defaults to stay low? 

Despite concerns about high interest rates, defaults in the predominantly floating-rate sub-IG private credit space have been surprisingly low. The opaque nature of the asset class means it is impossible to determine a precise default rate, but various data providers put it at between 2-4%[2].  

Strong earnings growth and cost management have been identified as the primary drivers. Another contributing factor is the increase in use of payment-in-kind (PIK) during 2024, which has helped borrowers conserve cash and avoid defaults. We don’t view the use of PIK as necessarily a sign of financial distress; it offers short-term relief to borrowers that need it, though it can introduce long-term risks. 

Rate cuts in the second half of 2024 will have eased the pressure, but the probability of higher debt cost for longer is significant. Borrowers who over-leveraged during the pandemic years and have been hoping to refinance more cheaply could therefore be vulnerable. We see lenders’ ability to collect PIK income being tested as the 2020 and 2021 vintages approach maturity.  

In our second instalment of our 2025 private credit outlook, we’ll look in more depth at the infrastructure and real estate debt market. 

 

[1]Source: Pitchbook, November 2024 

[2]Source: Proskauer, Goldman Sachs, KBRA