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Headline inflation has eased significantly this year, leading many private credit market participants to be hopeful a terminal rate is in sight for the Federal Reserve’s tightening program. The most hopeful are even predicting a Fed pivot to an easing regime is just around the corner.

Meanwhile, private borrowers are still dealing with sharply higher base rates and the impact of persistent inflation on both their top lines (in the form of softer demand) and their bottom lines (in the form of higher operating and input costs). These challenges are evident in many key coverage ratios private credit valuation professionals track, which have generally deteriorated. Nobody is panicking: Default rates are unremarkable, and private lenders and equity sponsors have been proactively monitoring and working on the “good” companies that have tight liquidity (including PIKing some interest, waiving covenants, putting in fresh equity) to get them through what most expect to be a temporary rough patch.

Still, a close look at private debt markets shows many borrowers need more wiggle room and are counting on a reversal in short-term rates or more forbearance from lenders.

Working Out the Disconnect Between Inflation and Short-Term Rates

Inflation and its impact on short-term interest rates—and, by extension, base rates for most middle-market floating-rate loans—is the most important context for private credit in the current environment. After peaking at 9.1% in mid-2022, the headline CPI figure has fallen precipitously—540 basis points—to just 3.7% in August.

But that’s not the whole story on inflation. Much of the drop in headline CPI is attributable to a decline in energy costs. Core CPI, which excludes food & fuel prices, dropped a much more modest 230 basis points over roughly the same period, from a peak of 6.6% to 4.3% currently. Similarly, Personal Consumption Expenditures, the Fed’s preferred inflation barometer, have fallen only about 310 basis points since mid-2022, from 6.40% to 3.30% currently. However, the measure ticked up about 30 basis points in July from June. To be sure, any easing in inflation is good news, but all three inflation gauges remain well above the Fed target of 2%.

After roughly a year of focusing on the splashy headline CPI numbers and second-guessing the Fed’s seriousness of purpose in fighting inflation, market participants are gradually coming around to the central bank’s point of view on short-term rates—but they’re still not there.

While the FOMC median projection for the Fed Funds rate in 2024 is 4.6%, versus a current effective rate of 5.33% (implying a 73 basis point reduction next year), December 2024 three-month SOFR futures imply 4.38%, versus a spot market rate of 5.4%, suggesting traders believe there will be more than 100 basis points of easing by the end of next year. The gap between market expectations and the Fed’s has narrowed compared to three and six months ago, but it is still a delta. Financial market participants may still be engaged in wishful thinking concerning the proximity and magnitude of a Fed pivot. Meanwhile, the Fed continues to guide to “higher rates for longer” until their 2% annual inflation target is in sight.

Credit watchers aren’t overly concerned about corporate borrowers’ ability to make it to the other side with respect to inflation/high short-term rates. Fitch is forecasting a modest increase in leveraged syndicated loan defaults over the balance of 2023, ending the year within a range of 4.0%-4.5%. That’s up modestly from 3.3% (by issuer count) in August. But the agency is forecasting loan defaults will level off thereafter in a range of 3.50%-4.50% for 2024.

In the strictly private market, the default outlook is even more optimistic. Direct Lending Deals forecasts a 2.5% default rate for sponsored borrowers and 2.25% for non-sponsored in 2023 (by issuers). The year-to-date figures are 1.5% and 1.3%, respectively.

Not-So-Golden Ratios in Private Debt

The impact of a slowing economy and higher inflation on middle-market borrowers is clear in several essential ratios. Whether it’s interest coverage (EBITDA / Cash Interest), adjusted interest coverage ((EBITDA – CapEx)/Cash Interest Expense), or cash flow coverage ((EBITDA – Cash Interest Expense – CapEx)/Net Debt), the median private borrower’s debt servicing capabilities have been severely impacted. The chart shows private loans of different vintage cohorts and how most borrowers’ debt servicing capabilities have declined significantly since issuance.

Effectively, loans originated before mid-2022 saw interest coverage ratios drop by an average of 1.0x, whereas cash flow coverage ratios dropped by roughly 400bps on average. On average, pre-mid 2022 deals have gross interest coverage ratios at around 1.75x, adjusted interest coverage ratios at approximately 1.5x, and cash flow coverage at roughly 5.0%.

Recent 2023 deals are getting done on more generous (for the borrower) coverage terms relative to historical coverage levels, as lenders are underwriting to some near-term EBITDA growth and lower base rates. Given these 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 underwriters historically demand. Their underwriting projections generally show an increase to the 2.0-2.5x interest coverage band as EBITDA grows modestly and reference rates tighten.

Sticking the Soft Landing

The Fed is on its final approach and looks right on vector for the soft landing that few thought it could pull off. Its aggressive monetary policy has inflation trending in the right direction, yet the economy is growing. But the runway—at least for many private borrowers, whose coverage ratios are stretched thin—is short, raising the stakes for policymakers to stick the landing.