KBRA Financial Intelligence

3 Things in Credit: Apollo’s Vision, CRE’s Stability, and Default and Recoveries Update

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Welcome, market participants, to another 3 Things in Credit. I’m Van Hesser, Chief Strategist at KBRA. Each week we bring you 3 Things impacting credit markets that we think you should know about.

So, Jay Powell, you got your 50-bp cut. Just as the economy printed a 3.0% bump in Q2 GDP, where financial conditions are highly favorable, and where corporate earnings growth is better than expected. And, oh yes, there was that off-the-charts jobs report today. Is this all lining up to be as good a landing as anyone could expect? Time will tell. But you might want to adjust the pace of your rate cuts.

This week, our 3 Things are:

1. Apollo’s vision. Growth of private investment-grade credit has implications for portfolio construction.

2. CRE’s stability. In the aggregate, it’s alright.

3. Default and recoveries update. Eric Rosenthal joins for his latest update.

Alright, let’s dig a bit deeper.

Apollo’s Vision.

When it comes to CEOs whose public commentary routinely transcends the ordinary, Apollo’s Marc Rowan is in my top echelon. So, I cleared the calendar this week to pay attention to his session at his firm’s investor day. He didn’t disappoint.

To be fair, it helps if your industry’s market structure is changing. And risk markets, including credit, are changing. And as a result, Mr. Rowan opines that “everything we know about portfolio construction makes no sense.” Alright, you’ve got my attention.

In a nutshell, Mr. Rowan believes the very nature of public markets and private markets is in flux, and that has very real implications for how investors should think about credit in general, and investment-grade in particular. More specifically, Mr. Rowan says we are transitioning from this deep-set belief, this conventional thinking, that private is risky and public is safe. “The world we live in today, he says, “is private is both safe and risky, and public is safe and risky.”

Eventually, he continues, investment-grade investors will not know the difference between public and private credit: “It will not be [driven by] the size of company. It will not be the size of [an] issue. It will not be the rating. It will not be the provision of financial information. And it will not be the liquidity. Everything that exists in the public market for IG is going to exist in the private market for IG.”

The liquidity comment is interesting. Today, investors that can handle the illiquidity of the private market can pick 150 bps or more of excess return for the same credit rating. There is the perception—again, deep-set—that the public market is more liquid. Now, anyone who has tried to trade an off-the-run public bond in the past 15 years knows liquidity is often a myth. Mr. Rowan said Apollo will begin market making in privates, and he believes other firms will follow. Eventually, he reasons, the liquidity premium is going to disappear. Asset manager excess return will come from the ability to originate, structure, and control a deal.

The times, they are a-changin.’

Alright, on to our second Thing—CRE’s Stability.

A piece came out of Deutsche Bank this week, provocatively titled, “Why hasn’t real estate crashed?” I love the title because, as the introduction notes, “Two years ago, real estate was frequently cited as the key thing that was likely to crash and contribute to an economic crisis.” The piece points out a number of things that we have been talking about for some time here at KBRA, namely:

• Most CRE continues to perform well, aided by a stronger-than-expected economic landing; since the outset of the pandemic, the FTSE NAREIT All Equity REITs Index total return is 26%, and this year it’s up 12%.

• Liquidity is returning to the sector: CMBS spreads in the aggregate have tightened meaningfully over the past year, and banks are selectively loosening up loan underwriting standards.

• CRE is more widely held today than it has been in the past, with reduced holdings by banks, who typically face contentious regulators in times of stress.

• In its place is opportunistic private capital, which is acting as a more effective shock absorber through the cycle.

• Risk to the banking system has been highly manageable, as the most vulnerable property type—downtown office—has been concentrated in the largest banks, where troubled exposure is minimal in the context of their massive lines of defense (earnings, reserves, and capital). Smaller banks tend to be concentrated in more durable property types: strip retail centers, suburban office and industrial, and warehouses.

• Office lease expirations are staggered, which mutes the impact and spreads the mark-to-market writedowns over time.

The DB piece does highlight the benefit of falling interest rates to the sector but acknowledges that falling rates usually pair with a growth slowdown. Nevertheless, in the first year following a rate cut, according to the piece, U.S. CRE appreciated in nine of the past 15 rate cutting cycles. The soft-landing expectation for this cycle, coupled with aggressive pandemic-driven marks, bode well for appreciation this go around.

Clearly, the office sector needs to find its bottom. The good news is that the sector accounts for around 15% of total CRE, so its ability to become a catalyst to significant economic slowdown simply isn’t there. And you can take that to the bank.

Alright, on to our third Thing—Default and Recoveries Update.

Joining me is Eric Rosenthal, who generates our default forecast as part of his work on our direct lending news and analytical platform, KBRA DLD (a division of KBRA Analytics).

Van: Eric, welcome back to the podcast.

Eric: Thanks, Van. Great to be back.

Van: Let’s set the stage for a second. In 2024, the economy has been more resilient than expected, to use Jay Powell’s favorite word. That has a lot to do with the still-meaningful effects of extraordinary stimulus rolled out during the pandemic era. But we do find ourselves in a higher cost of capital environment, which should weed out firms with deficient business models and/or inappropriate capital structures. As we enter the fourth quarter, what has been the biggest surprise in terms of 2024 defaults?

Eric: I would say the volume differential between year-to-date syndicated loans and high yield. KBRA DLD forecasted 2024 syndicated loan defaults would exceed high yield by the largest-ever margin. We estimated a roughly $20 billion differential between the two markets—well, right now, that number is $49 billion. Granted, that figure should end the year slightly lower. DISH is attempting a high-yield distressed debt exchange that could cut the gap by nearly $10 billion, though that is facing resistance from creditors. Still, even if the DISH DDE gets completed, loan defaults likely top high-yield by $40 billion or more in 2024.

Van: Let’s put some context around that. Your forecast entering 2024 called for a 3% HY and a 4% loan default rate by volume. Where are you now and what changed?

Eric: So, in July, we lowered the HY rate down to 2.25% from 3%. There were a few factors. A couple of potential sizable distressed debt exchanges, such as Commscope and Carvana, became highly unlikely as the year progressed. Our Default Radar Red list added very few names during the first half of the year, and general default activity was low as the economy hummed along, as you noted earlier. The YTD rate stands at 1.1%, and even adding $10 billion via DISH still puts it below 2%.

Van: Alright, let’s get into that loan story you teased a minute ago. What’s going on there?

Eric: Right, last month we lifted the forecasted rate to 5.25% from 4%. The upward move reflects a few projected DDEs that were done at larger-than-expected totals—Lumen and Travelport stick out. I would also note there was a surprise bankruptcy filing by Wheel Pros in September after completing a larger-than-anticipated DDE five weeks earlier. Still, the biggest impact involved Magenta Buyer, which wrapped a more than $4 billion DDE that was viewed as a likely 2025 action entering this year. Ironically, the number of 2024 issuers expected to default remains the same, at roughly 76, though the mix has obviously changed some. The universe has shrunk roughly 8% since year-end 2023, causing the issuer default rate to be raised to 6.5% from 5.75%.

Van: Got it. Where are we on direct lending? Have you deviated from the 2.75% issuer forecast?

Eric: We maintain the 2.75% rate for this year even though the default pace lags last year. There have been only 30 defaults, resulting in a 1.3% YTD rate, versus 38 one year ago. The view that the default rate would likely end lower than above our projections hasn’t changed, but the path to finishing at 2.75% remains. Why? The Default Radar Red list stands at 108 issuers, or nearly 5% of the KBRA DLD Index. With two BDC filing periods remaining in 2024, it is not inconceivable that one-third of the Red names default over that time frame.

Van: Let’s get into recoveries. Walk us through what the experience has been for each of the three segments.

Eric: The trailing 12-month direct lending average implied recoveries are at 57%, slightly higher than the 55% for syndicated loans and 46% for high yield. Recent direct lending defaults for Pluralsight, Anju Software, and Zipari produced lower results than the average. Further, the average fair value mark is 58% for our Default Radar Red list. The vast majority of these names that eventually default likely get marked down, resulting in even lower implied recovery levels. I should also mention for syndicated loans and high yield that the implied recovery rates are significantly higher for restructurings/DDEs than compared to bankruptcies/missed payments.

Van: Any other interesting default trends?

Eric: Yes, speaking of restructurings/DDEs, those comprise a significant portion of defaults. That is 72% of the trailing 12-month syndicated loans sample by volume. In examining syndicated loan defaults from 2008-2018, DDEs accounted for 8%, but from 2019 to the present, that figure increased to 43%. I see DDEs remaining the main default source in the future.

Van: Excellent, we will bring you back later this the year to discuss the 2025 forecasts.

Eric: Definitely. And hopefully we can bask in the Jets and Eagles leading their respective divisions and not jockeying for a top 10 draft pick.

Van: You had to bring that up! Talk about negative trends. Leaving that unseemly topic aside, remind our listeners where they can find your research.

Eric: We publish on a monthly basis both a direct lending and a liquid monthly default report, plus weekly default commentary on both markets. You can find these on our website at dld.kbraanalytics.com.

So, there you have it, 3 Things in Credit:

1. Apollo’s Vision. Pick up excess return in private credit while you can.

2. CRE’s Stability. In the aggregate, the asset class is holding up.

3. Default and Recoveries Update. There is growing divergence between high yield and direct lending and the loan market.

As always, thanks for joining. We’ll see you next week.