3Q 2023 Update: Middle Market Credit Spreads, Required Returns

Markets Tighten, 4Q Outlook Remains Cautiously Optimistic

By: Adrian Lowery

Estimated reading time: 1.5 minutes

Syndicated markets reached their low points from June to October 2022. Since then, prices and credit spreads improved but remain adverse to levels in January 2022. Market participants have a cautiously optimistic outlook for the remainder of the year despite continued concerns about the impact of inflation, higher borrowing costs from increased reference rates, and a potential recession. Syndicated credits spread were flattish-to-tighter quarter-over-quarter.

Q3 2023 Private Credit Price and Spread Changes

Based on VRC’s proprietary research in the middle market, 1st lien, 2nd lien, and Unitranche loan coupon spreads decreased by 25 bps since this year’s second quarter. Average OIDs increased by a half point to 98. These changes offset the 14 bps increase in SOFR, resulting in lower yields since Q2 2023.

Q3 2023 Traditional Middle Market Reference RatesSeveral factors drive the issuer-friendly changes, including easing recessionary concerns, stubbornly high inflation leading to higher-for-longer reference rate expectations, and increased competition amongst lenders given limited deal flow and additional fundraising. However, deal volumes remain limited as market participants remain cautious about sectors perceived as lower quality.

Direct lenders remain focused on interest coverage metrics as borrowing costs continue to increase in line with Spot Reference Rates. As a result, leverage levels and purchase price multiples are under pressure for some industries, especially those more exposed to inflation, macroeconomic concerns, and high CapEx requirements. However, direct lenders are considering both spot reference rates (3-month Term SOFR is ~5.4%, according to CME Group) and lower forward expectations (3-month Term SOFR forward curve declines to 4.7% in November 2024, per Pensford). However, forward expectations shifted materially higher since June 2023 (the 3-month Term SOFR forward curve was forecasted to decline to ~4.0% in November 2024, per Pensford), adding additional pressure on interest coverage ratios.

Given the lower forward expectations, direct lenders are willing to accept lower CapEx-adjusted interest coverage levels based on current spot reference rates (recently underwritten deals have a median and mean of ~1.5x and 1.75x, respectively) than the traditional 2.0-2.5x lower bound of required levels. However, underwriting projections generally show an increase to the 2.0-2.5x band as EBITDA grows and reference rates tighten.

Overall, valuation analyses need to consider case-by-case situations focusing on fundamental performance, outlook, affordability of debt, and available liquidity. Therefore, some credits will continue to fare better than others.

Q4 2023 Outlook

VRC continues to monitor market tone and expectations. Risks to the positive market dynamics remain, including, among others:

  • Impact of inflation and labor shortages on companies’ fundamental performance.
  • Impact of recession fears on consumer behavior and companies’ fundamental performance.
  • Impact of increasing reference rates on companies’ interest burdens and leverage levels.
  • Impact of the material shift upwards in the forward reference rate curve on direct lending underwriting standards.
  • Impact of the higher-for-longer reference rates on market credit spreads as these may put further pressure to tighten with the revised reference rate expectations.



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