Last week there was a great deal of media coverage regarding Metrics. We have not studied this company to understand their products well enough to comment, however, we do have some general observations on the private credit sector.
Investors initially buy these private credit funds because they are targeting a return of BBSW +350bps (@7.5% currently), the same level as the PIF. When they outperform and get returns above 10% investors assume that the credit risk is the same as the PIF so think that the private credit manager must just be really, really clever. The truth here is that the private credit manager has achieved a higher return by accepting a higher level of risk and lower liquidity. The private credit manager is incentivised to do this with an often large performance fee. Worse still the private credit manager is also taking a loan origination and service fee often not revealed.
Private Credit lending and investing surged in 2021 when the very low interest rates pushed investors into higher risk/higher return products and the banks were reluctant to lend to small & medium sized businesses that were forced by the pandemic response measures to be closed. These loans would have been made with a 5-year term so will begin maturing in the 2H 2025 and 2026 calendar year. This maturity wall will see a wave of restructuring opportunities (we would call them problems) and in many instances the borrowers balance sheets will include ATO liabilities that were not there in 2021. The pandemic lockdowns damaged the cashflows of many normally solid businesses. Many could not meet their ATO payments on time and were struck with 100% penalties. The ATO stands in front of all other lenders in a liquidation. Many of the loans made in the pandemic will not be able to be refinanced.
These private credit funds are sourcing their capital from wholesale investors (net assets more than $2.5m) that are often not well informed and usually not capable of truly understanding the risks taken when investing in private credit. What then happens is that as soon as there is flag on a credit fund (default) the wholesale investors rush to pull their money out of the fund. This creates a spiral of destruction for the fund as money is being lost with the default at the same time as capital is pulled out. This is something we have seen happen to investment banks many times before they were forced to severe the banking activities into separately regulated vehicles.
Governments are borrowing at record levels right across the developed world. The US budget and now the Australian budget never looks like being brought into surplus or even capped in the future. Now we have Germany and France uncapping their budgets and debt limits to invest in military hardware. The increased debt will mean increased sovereign bond issuance at higher yields. This will crowd out private borrowing because a sovereign bond yield is the starting point to price all credit risk. Last week a Westpac economist released a very good piece of analysis on this subject where she concluded that even if official rates fall, we are likely to see higher bond yields. Bond yields uncover the inconvenient truth about borrowing | Westpac IQ .
Australia has not had an economic recession since 1991 so there has not been a true test of the loan metrics offered by the private credit sector and in fact the banking sector. Investors in private credit are not getting an equity level of return with a debt level risk. They are getting an illiquid, promised high return AFTER the private credit fund has taken some big fees out and in reality, have the same risk with an unlisted company as an equity investor in an ASX listed company. In a recession there will be no way to sell the assets supporting the loans.
US Economic Outlook
Last week’s FOMC meeting held rates steady and there was a lot of conjecture in the media reporting of Governor Powells post meeting speech that frankly should be ignored.
The Federal Reserve was deliberately vague about the economic outlook because the economic outlook under the Trump Administration is very hard to forecast. The Whitehouse and Congress are seeking to change the way the US economy operates by shifting it away from being an economy driven by government expenditure to one driven by private sector activity. This is a fundamental shift not previously attempted since the Reagan era, and it is not without a lot of risk in the execution. Change is never easy, and it will be judged as worthwhile only in hindsight.
The reporting of Federal Governor Powell speech and the interpretations were disappointing. Many leapt on the use of the word ‘Transitory’ to conclude that the Fed will look through the impact on inflation of the tariffs. Talk about short term memories! The last time the Fed claimed that price increases would be transitory it was very wrong. Not a little wrong, but very wrong and still wrong today given the inconvenient truth that inflation is no longer declining and is still well above the Federal Reserve core PCE price index target of 2%.
Powell using the word ‘transitory’ to describe the impact of the as yet unknown extent of the tariff policy, is also fundamentally wrong when viewed in isolation. It would be transitory if the Federal Reserve acts to create negative money supply growth and transitory to the extent that Trumps Whitehouse term is limited to 4 years, but is that what he meant? Does he believe that the tariffs policy is illegal without Congressional approval and so won’t be implemented? By transitory he would then mean the impact we have seen already on import prices that will begin to show up in consumer prices in the June quarter.
If the tariffs policy causes a disruption to world trade that, like the pandemic lockdowns, triggers a surge in durable goods prices then this external shock may result in a ‘transitory’ increase in inflation. It will only be ‘transitory’ if the Federal Reserve acts to reduce money supply growth as it did in 2023 when M2 and M3 recorded negative growth numbers. Money supply growth is currently near 4% so if the tariffs result in a rise of inflation the Federal Reserve will have to act to reduce this temporarily.
Even if you had a ‘Keynesian’ view of the way the economy functions, we currently have a condition of ‘full employment’ at a time when Aggregate Demand is exceeding Aggregate Supply due to increases in Fiscal expenditure under the Biden Administration. Wages growth (Atlanta survey) is still above 4% and labour productivity growth that surged in 2023 (private sector returning to full capacity) to offset this wages growth is now moderating.
The inflation genie is not dead, not back in its bottle and still running amok in the village. If the DOGE planned cuts to the Federal workforce materialise, the impact on economic growth will not be seen for 6-9 months and it is too early to know if the Trump Administration and Congress will actually cut the level of fiscal expenditure at an aggregate level.
Interest Rates
The Fed meeting came and went with rates on hold and the Chairman deliberately vague about the economic outlook because such, under the Trump administration, is very hard to forecast. The Fed, like the rest of us, are caught between a potentially weakening economy and rising inflation. Shivers were sent down the spine of the market by the Chairman stating that any inflationary impact by tariffs maybe “transitionary”, as the last time this term was used by the Fed, it was totally wrong. Post the Fed meeting the market is no clearer of the rate cut path, with two cuts still priced in for the rest of 2025. The key economic data point will be employment numbers. Demand for treasuries has been strong in both gov. auctions and markets. This caused the whole treasury curve to drop, with 10-yr now at 4.25%, essentially in the middle of their 2025 trading range.
In Australia slightly weaker employment numbers caused rates to fall, however moves were subdued compared to the US. Most of the curve was down in yield by 1-3 pts. 10-yr. comm gov bonds are at 4.395%, still maintaining a premium over the 10-yr. US rate.
Major Credit Markets
US investment grade (IG) spreads continue to widen at a small pace. Capital prices for fixed rate bonds however have been reasonably steady given bond reference rates have also fallen. US trading banks have increased their forecasts for spreads given a recession, albeit small, has risen compared to a month ago. However, IG balance sheets are still strong. Volatility of spreads is currently well correlated with the direction of the equity market.
Australian IG credit market spreads fell over the week with a rebound in Aust. equities. The recent weakness in the Tier 2 sub-note sub-sector abated with buyers cautiously moving back in, however the fears of more issuances remain. Most issuance remains from offshore entities or second tier issuers. Clearview Wealth (rated BBB) issued $120m of a Tier 2 floating sub-note at BBSW+3.50%. The actual bonds will be non-IG rated at “BB”. Stockland (rated “A- “) issued a seven-year senior unsecured bond at 5.42%, a margin of 1.40%.
High Yield Markets
US high yield spreads were steady over the week after recent jumps. Recently the HY media sub sector has been the worst performer. Put option volume on HY ETFs has soared in March. Investors are buying protection rather than selling the physical bonds.
Hybrids firmed over the week with the average major bank hybrid margin falling by 0.07% to 1.92%. Volumes were elevated as investors looked to replace the redeeming AN3PH’s $930m. The average daily volume for the week was $38m, well above the usual $30m. The short dated WBCPH again featured as top volume – investors rolling to an alternative short-term issue. Otherwise, volume was elevated in Dec 2027 NABPH and longer dated issues past 2029.
CBA announced the redemption and final pro-rata payment for CBAPG to be on April 15 as expected. No reinvestment offer was made. CBAPG is a $1.3bn issue.
Listed Hybrid Market
Hybrids rally on AN3PH redemption.
As mentioned above, the AN3PH $930m redemption funds were received in bank accounts on Thursday. Volume on that day was $42m, Friday $34m, both well above average. The chart below shows the moves in margins from a week ago (red) to Friday close (blue). Overall, the curve has moved down. Blue dots tend to be below red dots signifying margin contractions, except in the middle of the curve, where WBCPL, AN3PJ and CBAPK all moved wider. There is also a group with maturities mid 2026-2028 (circled) which are trading well below the curves. These should be switched into longer dated issues for a 0.30-0.40% margin pick up.
