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The first one hundred days of the second Trump administration has been eventful to say the least. The announcement of impending tariffs on Mexico, Canada and China raised concerns of global trade war increasing the risk of recession. Some strategists have gone so far as to say a recession in the US is now a 90% probability. Naturally, this has investors on edge and private credit’s not immune to this speculation.

Much has been written about the hidden risks among the direct lenders. Countless articles about the percentage of payment-in-kind (PIK) loans within business development company (BDC) portfolios predict doom. The truth is PIK loans are not all created equal. Private lenders often use PIK features as an attractive way to build in flexibility for a company that is looking to grow. Furthermore, from what we observe the large private BDCs have a lower percentage of PIK loans than the public BDCs the articles are quoting. Further, the vast majority of these loans are what we would call the ‘good’ kind of PIKs.

Instead, we focus on other fundamental metrics like interest coverage ratios, non-accruals and leverage. Interest coverage ratios are lower today compared to 3 years ago given the rise in interest rates and the resulting increase in borrowing costs for private credit borrowers. However, the revenue growth and EBITDA trends have been stable. Furthermore, there are no immediate signs of financial stress in the sector as the leverage profile has been consistent and the non-accrual loan percentage have remained low for our investments. Granted, these operate in a lag as fundamentals deteriorate but we’ve seen no negative trends emerge as of yet.

Despite what the market spreads are signaling, we believe a long drawn-out credit cycle has already begun. With the rise in rates due to ‘transitional’ inflation post-COVID-19, we began to see an increase of default activity in the broadly syndicated loan market (see Figure 1). To date, the increase in defaults and default exchanges is primarily limited to poor documentation and liability management exercises but the default rate will accelerate if growth slows as more companies will fall under pressure.

Figure 1: Issuer-weighted speculative-grade US bond vs. US loan default rates (%)

However, the flexibility of private lenders can be a significant advantage over the public markets in difficult times. In fact, we’ve seen a number of companies opt for the private market to fund their companies citing this flexibility despite the higher cost of capital.

While the direct lending strategy is exposed to a default cycle, we believe the funds we’re partnered with have robust portfolios and talented teams that will be able to weather the storm and come out as strong as ever.��In fact, we would characterize the ability of our lenders to provide borrower flexible solutions as an opportunity, not a risk. Lenders able to look through the storm and back��high- quality companies during rocky times will profit. You could even call these lenders a bridge… over troubled waters (corny, I know).

In fact, after many years of a mild opportunity set, special situations strategies in corporate credit could be heading for a comeback. Over the past decade and a half, the holders of public market debt (high yield and leveraged loans) have shifted dramatically. Mutual Funds, ETFs and collateralized loan obligations (CLOs) have no ability to hold stressed or distressed debt, never mind execute actual workouts. If a recession does emerge and the default rate continues to climb, new capital focused on special situations and capital solutions investing will finally find themselves back on top of the performance tables. It may still be early but we’re keeping an eye on these opportunities.

Through the storm of volatility and headlines, commercial real estate pricing increased slightly in the first quarter after nine consecutive quarters of declines. Commercial real estate faces dual challenges related to the move in interest rates – higher borrowing costs and higher cap rates. Both of these factors, coupled with select fundamental pressures, can ultimately lead to property-specific challenges when it comes to refinancing existing loans or servicing debt. However, unlike corporate where equity remains near all-time highs in valuation, commercial real estate (CRE) has already repriced following the increase in rates post-COVID-19. The only outlook that is certain for CRE is uncertainty. As always it comes down to location. We expect continued dispersion by region, sector and property.

Similar to the theme in corporate credit we believe this could be a great opportunity for opportunistic strategies. Lenders with fresh capital have a large and diverse market of assets various states of stress. Finding quality properties with bad capital structures in need of fresh capital is a theme we expect to focus on in our opportunistic private credit investment strategy. Given the adjustment in CRE valuations mentioned above, lenders can originate new loans at compelling loan-to-values (LTVs) with significant downside protection.

On the income side, we continue to focus on short duration strategies. We’ve expressed this theme for years now. During times of uncertainty and volatility shifting your duration down the curve can protect investors looking to earn safe, secured income. We continue to focus on high quality sectors and particularly multifamily property. Overall, property fundamentals have been generally improving. The multifamily vacancy rate declined in the first quarter for the first time in three years. While new supply in multifamily continues to come to market, new multifamily housing starts have declined significantly over the last few years, which should ultimately help create a more favorable supply/demand dynamic in the future as the existing new development supply is worked through.

Additionally, post the Silicon Valley Bank (SVB) collapse, regulatory pressure on regional banks has reduced competition significantly, particularly in construction lending which continues to be a core component of our short duration strategy.

In addition to construction lending, multifamily bridge-to-agency remains another core component to our short duration strategy. We’re always looking for investments where we believe the yields don’t reflect the real risk profile. As such, we’re always on the lookout for strategies that take advantage of non-economic players like government sponsored entities who adhere to strict guidelines while executing their mandate. We believe the credit and refinancing risk in our bridge-to-agency strategy is very low compared to the high yields we’re earning.

For the past 15 years, we’ve been extoling the virtues of residential real estate as a sector for lenders. The main reason was the fundamental supply/demand imbalance created by the gap between new household formation versus and new home creation (see Figure 2). Today, these statistics are more in line with monthly home creation consistently ranging higher than household formation over the past 12 months.

Figure 2: US household formation

While a more balanced supply demand picture doesn’t provide the tailwinds it has in the past, we maintain the view that residential real estate remains one of the most attractive credit profiles available in the market. Consumer balance sheets are well positioned as homeowners have built a large cushion of equity in their homes and have very manageable debt service costs. While the prevailing mortgage rates are near the highest levels over the past 15 years, the vast majority of the US housing stock either has no mortgage or has a mortgage the was originated prior to 2022. As a result, most homeowners with a mortgage are benefiting from having a fixed borrowing cost that are relatively low.

Negatively, high current mortgage rates have stretched affordability to an unsustainable point which could lead to modest declines in home prices if rates don’t come down. Additionally, increase supply in certain metropolitan statistical areas (MSAs) could put pressure on home prices. These markets have typically been the benefit of high demand strong home price appreciation (HPA) over the past few years.

Overall, we believe investors need to be more discerning than in the past. Strategies that were more heavily reliant on HPA growth could produce disappointing results going forward. We remain focused on short duration residential real estate credit strategies that perform well in most forward-looking home price environments, not strategies that rely on rising home prices to achieve target returns.

Specialty finance is a bit of a catch all for everything that doesn’t fit neatly into corporate credit and real estate. Most investors immediately think of consumer lending, but the definition encompasses everything from corporate receivables to litigation finance to health care royalites. As this covers diverse areas of assets and strategies, it’s very difficult to have an outlook on the space.

Overall, we believe there are areas that will continue to produce attractive uncorrelated yields and others that will be highly susceptible to a downturn in the economy. We’re being cautious in the consumer and small business lending space favoring a more senior position in the capital structure and a shorter duration profile where the portfolio velocity is higher allowing investors to recycle more capital into periods of widening spreads.

Additionally, we’re able to source more niche strategies that while not as scalable can produce very attractive yields with limited credit risk. Many of these strategies are complex and have others risks investors need to evaluate such as origination capacity, execution risk, etc. We’ll continue to look to expand our stable of these strategies going forward.

While pricing for collateralized reinsurance is off the highs of late 2023 / early 2024, it’s still quite attractive in a historical context.

While the expectation is that pricing for mid-year contracts (which largely reference US wind-related losses) will modestly soften, there is anticipated to be a notable amount of dispersion with more remote contracts seeing more material price reductions. Less remote and recently loss-affected contracts are less likely to see significant price declines (and will likely see price increases in select cases).

January’s California wildfires are likely put a floor under pricing for many contracts, but are not likely to have a major impact on pricing (perhaps because of a perceived greater likelihood of some recoveries via subrogation to the local utility company).

The hurricane season is expected to be fairly ‘normal’ in contrast with the more active than usual season that we witnessed in 2024. Sea surface temperatures in the main development region (MDR) of the eastern Atlantic have cooled markedly since last summer. This should be a mitigating factor in hurricane development and intensification.

Cat bonds still offer reasonable value from a historical perspective, but to a lesser degree than collateralized reinsurance. Both risk-free rates and cat bond spreads are lower than at the same time last year, while expected losses have remained fairly static. As such, loss-adjusted yields are projected to be in the high single digits vs. the low teens at this time last year.

As a credit investor I can attest we’re a negative lot. Credit is a negatively convex asset class, meaning we primarily face downside risk. As such, credit investors focus on potential risks when underwriting investments, which often leads us to hold a more cautious view than the market. We operate with the mindset that a recession is always just around the corner.

Ironically, when the market starts to share our concerns and focus on risk, we often feel more at ease, even in a deteriorating environment, because that’s what we’ve anticipated. I’m not suggesting that credit performance will be immune to a recession, but I don’t think investors should panic. If you’ve been a prudent investor, and we believe we have, the downside is probably manageable.

Additionally, investing in credit when the water is the choppiest can be the most rewarding. We believe the current environment is a favorable one for our strategy. Even in a recession, where overall credit markets deteriorate, we believe our asset selection can shield investors from credit losses, while elevated interest rates can deliver attractive carry for investors. Being positioned short duration and at the top of the capital structure has its privileges and this is never more valuable than when a storm approaches.

Private credit sector performance outlook¹