'Gradually Climbing the Foothills' of Credit Risk: Polus Capital

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00:00I think we're just still gradually climbing the foothills, to be quite honest with you.

00:04It's been an incredible pickup in leverage over the last 15 years. And what we're seeing now are

00:10only those initial indications of misallocation of capital that are coming to the fore because

00:17we've been in a period of slightly higher interest rates for two to three years now.

00:23We're starting to see a decent level of bifurcation in earnings that we know of, bifurcation in the

00:30economy. And those things are creeping into this gradual growth in defaults. Naturally,

00:39you know, we will see at what point that eventually becomes something that accumulates into something

00:44slightly larger. Robert, how long do you think until we see the peak of defaults?

00:50Well, honestly, that's very, very hard to tell. And it may not be a statistic to be worth

00:58watching, to be quite honest with you. The actual level of defaults that you would see recorded

01:03these days tends to be actually the level of hard defaults rather than those that incorporate

01:09kind of effectively situations where creditors are taking losses, but perhaps just amending and

01:16pretending into the future or conducting liability management exchanges to convert a stressed credit

01:22into something that, you know, is still outstanding, hasn't gone through default, but is unlikely to

01:28pay later. So, I think the relevant statistic is going to be how many defaults and shadow defaults

01:34are there in the system? Will we actually be able to count those in private credit? Will they be

01:39accurately reported? So, I actually think this time that the following kind of what looks like a default

01:45rate might actually not be as worthwhile as it has historically. We'll have to look at those other

01:50signals, things like bank charge offs, which continue to slowly rise, consumer delinquencies,

01:55et cetera, and so on and so forth.

01:59So, if you look at, you know, the pain threshold, is it more banks or actually private credit firms that

02:04will suffer the most? Well, or actually expanding that to other parts of the market. I think that

02:11typically the banks do tend to syndicate their more levered risk. So, you know, there are pockets

02:19of leverage everywhere. What's going to matter is which of those misallocated pockets of credit

02:25becomes the issue. I think in the banking system, we know that there is an amount of lending and

02:32leverage facilities into the private capital market. So, there is that link between private

02:37credit and the banking system, you know, via the leverage on those funds. So, they're not immune

02:44from the issues. Obviously, what we also know is that private credit funds have actually been buying

02:50a lot of the syndicated risk rather than the banks produce, rather than actually kind of self-sourcing

02:57that risk. So, in the end, they own a lot of relatively similar risks also. So, but I wouldn't

03:04say that those are the only pockets of issues, right? I mean, there's a lot of leverage in the

03:09system, be it leverage, you know, via margin in the stock market, on crypto. But let's not, of course,

03:15forget the high yield market where those weakest exposures are as well for the corporate market. So,

03:21I would actually expect potentially all of those different pockets to suffer some issues at some

03:27time. I think ultimately what matters is also going to be the liability structure of how that debt is

03:34owned. You know, I think people often think private credit is going to be immune from issues because

03:40these are closed-end vehicles and therefore they don't necessarily have that run on the liabilities

03:46that you can have. But ultimately, these funds do have to sort of effectively send their money back

03:52to their investors at the end of the fund life. And that will be a very interesting process for us to

03:57see. Robert, are there any sectors actually that you worry most about for defaults? I know there's been

04:05a lot more interest in, for example, software lending, which is facing pressures because of AI.

04:11Yeah, I mean, it's actually quite a few different corporate sectors for various different reasons.

04:19So, thinking cyclically, there are a number of weak sectors from that perspective. You only need to

04:25read the headlines to understand it's not that strong conditions for many of the highly cyclical

04:31interest rate sensitive sectors. So, building materials, companies globally are finding it relatively

04:37hard at the moment. We know the same of developed market chemicals companies has been a lot of

04:44headlines over the challenges for that sector recently as well. So, I think it kind of you can

04:50actually go much more simply and think, well, which sectors are, you know, to some extent struggling

04:56in this cyclical environment because we have a very bifurcated world on the earnings side at the

05:01moment. But I think kind of it goes without saying that over time we will be seeing losses in the

05:08software sector. I mean, I think artificial intelligence as a theme will see some relatively

05:15interesting credit losses, partly because of kind of stranded assets that will eventually emerge

05:22on the kind of harder asset side. But on the software side, potentially those situations which

05:28where the coding has been done more cheaply and hence the product replicated via those systems.

05:35So, you know, certainly that having been a big area of growth for the leveraged credit and private

05:42capital markets is why it poses a risk over the coming periods. But that may actually be a sector that

05:51incurs losses slightly later than the more obvious cyclical ones with this bifurcation.

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