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Cut and Run? Not So Fast... Private Credit and the Fed
By: Andrea Picard, Golub Capital
This piece helps investors understand what impact future Fed actions may have on the direct lending asset class, given its floating rate structure, and makes the case for maintaining a core direct lending allocation throughout the interest rate cycle.
This is an excerpt from NCPERS Winter 2025 issue of PERSist.
The case for maintaining a core direct lending allocation throughout the interest rate cycle.
How much will the Fed cut rates -- and when? These questions have dominated headlines throughout 2024; odds are the same will be true in 2025.
All this raises a question for allocators to floating rate direct lending strategies: Should they seek to trim their direct lending exposure in the expectation that declining rates will lead to lower returns?
Our experience suggests not: We believe the consistent, premium returns of direct lending strategies are compelling, regardless of the prevailing interest rate regime.
History suggests that there's merit to making direct lending a core allocation. Exhibit 1 shows that quarterly income from direct lending has remained consistently strong, at between 9% and 12% annualized (between 2%-3% quarterly), even as Fed funds rates have fluctuated over the last two decades — including a long stretch near zero.
From a total return perspective, duration-sensitive fixed income portfolios benefit in the short-term from unrealized gains associated with a decrease in rates. Intermediate bond returns with over six years of duration, as measured by the Bloomberg U.S. Aggregate Bond Index, have a high degree of dependence on changes in benchmark Treasury rates. Over 70% of the quarterly return of “the Agg” is explained by 10-year yields, compared to just 30% for direct lending.1 In another analysis, we look at the returns of direct lending in all quarters since 2004 where T-bills moved up or down by more than 10 bps. As expected, median direct lending returns are higher in rising rate quarters (1.6%) than in falling rate periods (1.3%), but the difference is modest.
The good news for investors in direct lending strategies is that their total return “disadvantage” to traditional fixed income in periods of falling rates isn't as significant as one might think. Exhibit 2 shows that intermediate-duration bonds have historically outperformed direct lending from a total return perspective by about 46 bps during periods of falling 10-year rates.2 But, consider the inverse: direct lending has historically outperformed by about 311 bps during periods of rising 10-year rates.
Given how consistently consensus expectations about interest rates have been wrong during the last four years, we would argue that attempting to time the duration trade offers much more risk than potential reward.
Lower base rates also come with benefits for direct lending strategies that we believe mitigate return headwinds. Lower base rates reduce the cash interest expense of borrowers, which increases their margin for safety against operational setbacks. M&A activity tends to pick up when rates decline, which can create attractive deployment opportunities.
And for investors in leveraged direct lending strategies, a carefully matched portfolio of floating-rate assets with floating-rate liabilities can capture a consistent credit spread.
It may be tempting to view direct lending through a tactical lens, but we think investors should understand it as a strategic allocation.
Endnotes:
1 Stephen Nesbitt, Private Debt, Wiley, 2023, page 54.
2 Ibid. Nesbitt, page 56
Disclosures: Information is current as of the stated date and may change materially in the future. Golub Capital undertakes no duty to update any information herein. Golub Capital makes no representation or warranty, express or implied, as to the accuracy or completeness of the information herein. Views expressed represent Golub Capital's current internal viewpoints and are based on Golub Capital's views of the current market environment, which is subject to change. Certain information contained in these materials discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as investment advice. There can be no assurance that any of the views or trends described herein will continue or will not reverse. Past events and trends do not imply, predict or guarantee, and are not necessarily indicative of, future events or results. Past performance does not guarantee future results.
Bio: Andrea Picard, Managing Director, Co-Head of Global Institutional Sales, joined Golub Capital in 2024 and is a Managing Director and Co-Head of Global Institutional Sales within the Investor Partners Group. She is responsible for business development and investor relations for the Firm. Prior to joining Golub Capital, Ms. Picard was Managing Director in the Americas Institutional Business at BlackRock, where she was the Head of U.S. Pensions. Prior to this position, she was a Partner and Director of Marketing at Stelliam Investment Management, where she led the marketing and client relationship team. Prior to that, she worked at Raven Asset Management. Ms. Picard began her career at Lehman Brothers. Ms. Picard earned her BA degree in Linguistics from the State University of New York at Albany. She received an MBA in Finance from the NYU Stern School of Business.
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