Macro

Pimco Warns Credit Market Returns Insufficient, Liquidity Premiums Below 100 Bps

Pimco warns liquidity premiums in credit markets have dropped below 100 basis points, with 40% of private borrowers struggling.

By Max Weldon

7/10, 13:18 EDT
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Key Takeaway

  • Pimco warns that credit market returns are insufficient for the risks, with liquidity premiums below 100 basis points.
  • Public and private credit markets face elevated vulnerability due to economic slowdowns and higher interest rates.
  • Pimco shifts focus to high-quality, liquid public fixed income like agency mortgages and senior structured products.

Liquidity Premiums Compress

Investors are facing a challenging environment in the credit market, with liquidity premiums compressing significantly. According to Mohit Mittal, Chief Investment Officer of core strategies at Pacific Investment Management Co. (Pimco), the excess premium for less-liquid investments has dropped below 100 basis points, which is less than half the return it should offer. Mittal highlighted that "liquidity premiums have compressed in both public and private credit markets, with lower-quality segments of each facing elevated vulnerability to economic slowdowns and higher interest rates." This compression is leading to unattractive valuations for new investments, with corporate spreads across public and private credit markets near record lows.

Pimco has responded by shifting its public credit exposure to areas with healthier liquidity and risk premiums, such as agency mortgages and senior structured products. The sharp rise in global market interest rates since 2022 has made high-quality, liquid public fixed income more attractive compared to most alternatives across the risk and liquidity spectrum. Mittal emphasized that low liquidity and risk premia from private credit are insufficient relative to the opportunity costs associated with rebalancing, lost alpha from public fixed income, and potential costs of cash shortfalls.

Risks in Private Credit

The private credit market is showing signs of stress, with a significant portion of borrowers struggling to meet their financial obligations. Mittal noted that approximately 40% of private credit borrowers, up from 15.9% two years ago, are not producing enough cash flow to service all debt, taxes, and capital spending needs. If interest rates remain elevated and economic growth slows, these borrowers could face increased leverage, declining credit quality, and higher expected losses.

The role of primary dealers in making prices and supplying market liquidity has diminished, with public fixed income liquidity remaining robust due to innovations like ETFs and portfolio trading. However, the inherent difficulty of valuing non-traded loans in private credit markets poses a significant risk. As Gary Gensler, Chair of the Securities and Exchange Commission, stated, "I think there’s risks that can build up inside of this private funds world." The lack of market data for objective valuations means fund managers must rely on their own understanding and third-party valuation providers, which can lead to discrepancies and potential mischaracterization of risks.

Divergent Valuations in Private Credit

The case of Pluralsight, a workforce technology company, highlights the risks associated with divergent valuations in private credit. The $1.7 billion debt provided to Pluralsight by various lenders has seen significant discrepancies in valuations, with marks ranging from 83.5 cents to 97 cents on the dollar. This divergence has become more pronounced as the company faced financial difficulties, leading to a messy restructuring process.

The loans to Pluralsight were extended in 2021 as part of Vista Equity Partners' $3.5 billion buyout of the company. The novel loan was based on Pluralsight's revenue growth rather than cash flows or earnings, a type of credit deemed too risky for regulated banks. As the company struggled, several lenders began to write down the loan, with Vista ultimately agreeing to inject more capital to prevent covenant breaches. The most conservative mark implies a loss of nearly $280 million on the $1.7 billion debt package, while the highest mark suggests a loss of just $50 million.

Street Views

  • Mohit Mittal, Pimco (Bearish on private credit markets):

    "Liquidity premiums have compressed in both public and private credit markets, with lower-quality segments of each facing elevated vulnerability to economic slowdowns and higher interest rates."
    "New investments are entering at potentially unattractive valuations, with corporate spreads across public and private credit markets near record lows."

  • Mohit Mittal, Pimco (Bullish on agency mortgages and senior structured products):

    "Pimco has shifted its public credit exposure to areas that we believe offer healthy liquidity and risk premiums, such as agency mortgages and senior structured products."

  • Mohit Mittal, Pimco (Bullish on high quality liquid public fixed income):

    "A sharp rise in global market interest rates since 2022 favors high quality, liquid public fixed income... these more mainstream starting yields look very attractive compared with most alternatives across the risk and liquidity spectrum."