News in brief

“The concern is that over the next year or two the beta may not be as compelling as it was during the past two or three,” said Stephen Ketchum, founder and CEO of Sound Point Capital Management, on the Credit Exchange podcast with Lisa Lee.

Income generation in credit, particularly in private credit, has been good in the years since 2020. But there is now more investor capital looking for opportunities, leading to tighter spreads. The market is seeing a reduction in the reward for mainstream areas of private credit, like corporate direct lending.

“Size is the enemy of performance in any investing asset class,” Ketchum said. “It is easier to generate great performance and alpha in a USD 2bn fund than a USD 20bn fund.” As more money is raised in private credit, investors will have to work harder to find opportunities that generate excess return.

Large funds end up looking at larger deals and competing with the broadly syndicated market, which results in lower spreads and worse covenants, he said. That can create challenges in the private credit world.

In the broadly-syndicated loan market, weak documentation has set up the field for lender-on-lender violence to proliferate.

“One of the challenges is that instead of being able to trust your friend group and know that we’re fighting with the other lender groups, you have to sleep with one eye open,” said Ketchum. Being a large CLO manager helps in restructurings, but the widespread use of LMEs has helped lawyers more than anyone else, he added.

The proposed changes “largely unlock a wide range of mortgage SRTs as a construct,” said Robert Bradbury, head of SRT at Alvarez & Marsal. “Banks will look at this and realise that the impact can be significant.”

Although mortgage SRT already exists, it makes up a small chunk of the market. Banks currently have a bigger incentive to use SRT to gain capital relief on other assets for two reasons.

First, residential mortgages already enjoy low risk weights, so banks can often bag more capital relief by using SRT on riskier, less granular assets like corporate loans.

Second, because mortgages have low risk weights and banks face high risk weights for holding senior securitised tranches, the benefit of using SRT on mortgages is often negligible.

Banks using the Basel banking framework’s internal ratings-based approach often face a capital charge around 10% on an STS senior tranche, which is equal to the current risk-weight floor of 10%, research from Alantra shows.

Cutting the risk-weight floor to 5% would allow banks to make bigger capital savings using SRT. For mortgages with higher loan-to-value ratios, the benefit is even bigger.

“Mathematically speaking, it looks very attractive,” said Jeremy Hermant, SRT lead at Alantra.

Private credit managers extend ARR loans to software companies with the expectation that they will reach profitability quickly and flip to a more typical EBITDA-based loan.

“Falling ARR is a major determinant of future stress and default,” KBRA noted in a report assessing 189 ARR loans. Most ARR loans have covenants requiring continued ARR expansion and a mandatory conversion to an EBTIDA-based loan after a few years. 34 borrowers must convert in 2025 or 2026.

Based on portfolios of actively managed recurring revenue loan ABS transactions, a separate KBRA report found that the weighted average annual recurring revenue of borrowers tumbled more than 30% year-over-year to USD 178.9m at the end of the first quarter. Borrowers also saw liquidity cushions thin to a weighted average of USD 50.5m, which represents a 37% decline year-over-year. Balance sheet cash fell below the historic average of USD 49.1m to USD 36m.

Though these declining metrics may raise eyebrows, KBRA noted that the weighted average ARR remains above the historical average of USD 174.1m and that RRL ABS naturally suffers from portfolio churn. This is because when a loan converts from ARR covenants to EBITDA, it is removed from the recurring revenue loan population.