As the Federal Reserve moves through its rate-cutting cycle, private-credit firms are watching their yields compress in real time. The same structural feature that made these loans so lucrative when rates were climbing, their floating-rate nature, is now working against lenders as borrowing costs decline.
The mechanics of the squeeze
Most of the loans in these portfolios are tied to floating benchmarks, primarily the 3-month Secured Overnight Financing Rate (SOFR). When the Fed hikes, SOFR goes up, and lenders collect fatter interest payments. When the Fed cuts, the opposite happens.
New deals being originated in today’s environment are also coming with lower credit spreads than what firms were able to command during the high-rate era. The base rate is falling, and the premium on top of that base rate is shrinking too.
Lingering hangovers from the high-rate era
During the period of peak interest rates, many private-credit managers extended various forms of relief to borrowers struggling under the weight of higher debt-servicing costs. These mechanisms, which could include payment deferrals, amended terms, or other concessions, were a way to keep portfolios from showing cracks. Those relief measures continue to weigh on portfolio performance even as the broader rate environment shifts.
Labor market weakness has prompted the Fed’s recent cuts to address slower job growth. A company that was already stretching to service its debt at higher rates doesn’t automatically become healthy just because its interest payments drop by a percentage point or two.
Relative value still exists, but the gap is narrowing
Even with declining yields, private credit retains a premium over public bond alternatives. Investors still earn more lending through a private-credit fund than they would buying investment-grade or even high-yield corporate bonds in the public market.
The risk that deserves the most scrutiny is the intersection of lower yields and higher defaults. If the economic slowdown that prompted the Fed’s cuts leads to deteriorating credit quality among borrowers, private-credit firms could face a scenario where they’re earning less on performing loans while simultaneously absorbing losses on those that stop performing.
