Credit

Seeking stability in an uncertain environment with Direct Lending

By Sean Connor, President & CEO
December 22, 2023
Less than 4 min read

When constructing portfolios, investors seek predictable returns in pursuit of their financial goals.

Today’s environment has proven to be a challenging place to accomplish that. While there are many factors at play contributing to the state of markets in recent months, there are two at the center of it all – inflation and rising interest rates. The pressure of these forces has not only created a highly volatile marketplace, but it has also seemingly exposed the vulnerability of the traditional banking model and the longstanding risks associated with asset-liability mismatching, elevating fears of more systemic issues in the banking system.

Against this backdrop of uncertainty, investors must continue to explore solutions outside of the public markets in pursuit of resilience. Historically, allocating to alternative strategies such as direct lending has helped to provide stability to portfolios during unstable times. Our goal in this piece is to help financial advisors and their clients understand the potential opportunities in spite of the market’s unrest.

As you may know, direct lending is a strategy within private credit in which non-banks make loans directly to private companies. These companies can be small/medium-sized businesses or large corporates and are backed (owned) by private equity firms. The certainty of capital that direct lenders can provide to borrowers enables them

to command yield premiums, increased diligence, and better documentation than bank lenders. Direct lenders seek to hold their loans to maturity and pass interest payments through to investors in the form of periodic distributions. Scaled managers like Blue Owl fund these loans primarily with permanent capital raised from institutions and private wealth investors, which means their capital is not at risk of a “run on the bank.”

The global economy remains in transition in 2023:

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The 60/40 portfolio is cracked under stress

Public assets have stumbled considerably and the traditional 60/40 portfolio, once considered the standard of diversification, suffered its worst results since the stock market crash of 1937 as equities and bonds fell in tandem in 20224.

Of particular note is the 40% component: Due to the inverse relationship between fixed rate bond prices and interest rates, the aggressive rate hiking schedule employed by the Fed to curb inflation proved disastrous for fixed income portfolios. The Bloomberg U.S. Aggregate Bond index, designed to represent the full range of investment-grade corporate and treasury bonds traded in the U.S., suffered its worst calendar year since the inception of the index.

Fixed income is meant to play a stabilizing role in a portfolio, providing income and negatively correlated returns to public equities, but investors may need to recalibrate these expectations. Why? Over the last three years, we have seen the opposite and historical data suggests the high positive correlation between stocks and bonds will continue to stress the 60/40 portfolio this year. Layer on a growth slowdown, the threat of a recession and potential erosion in corporate fundamentals, the 60% is also likely to underwhelm as price appreciation becomes more elusive.

Challenges remain for the traditional 60/40

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Redefining the '40' in today's market with direct lending

This breakdown of conventional diversification wisdom poses an important question how can investors approach portfolio construction in the context of today’s market? The answer for an increasing number of investors has been the inclusion of alternative investments to introduce less-correlated,

risk-mitigating assets into their portfolios. With more defensive features and a floating-rate structure, we believe an allocation to direct lending may offer compelling benefits in a portfolio. Here are three reasons why:

1. Rising interest rates can bolster direct lending's earnings power.

When interest rates increase, the values of fixed-rate debt investments are negatively impacted. Direct lending is insulated from rising rate pressures because the loans being made are floating rate, earning a credit spread (risk premium) plus a floating benchmark rate such as the Secured Overnight Financing Rate (SOFR). To put it simply, the all-in yields of these loans increase as interest rates do, which boosts income and has driven direct lending’s outperformance versus bonds during prior rate hiking regimes. Through a combination of improved terms and widening credit spreads in the last year, newly originated loans can feature yields of 12% or higher today.

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2. Increased downside protection in tougher economic environments.

Periods of sustained inflation and higher rates can be followed by economic slowdowns with rising credit risks. Direct lending assets are typically secured by the borrower’s assets (cash, receivables, inventory, property, etc.) and can include a comprehensive set of protective covenants that require borrowers to maintain certain financial conditions and restrict them from taking on additional debt. Often, they are also traditionally the most senior assets in a company’s capital structure, giving them payment priority ahead of all other investors in the event of a default. While increased borrowing costs may push defaults higher in 2023, the median first lien recovery rate is 96% across all first-lien term loans over the last 20 years7.

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3. A history of outperformance throughout the economic cycle.

While direct lending maintains a defensive posture, this does not come at the expense of performance. The asset class has a track record of delivering consistent risk-adjusted returns across market cycles, particularly when compared to public leveraged finance markets and equities. This is because its returns are driven primarily by income and capturing that benefit doesn’t require market timing. Since 2005, this income advantage has averaged 389bps and 542bps versus the U.S. high yield and traded loan markets9. Over the same timeframe, the market has provided 100% of the returns of U.S. equities with only 25% of the volatility10. This combination of increased income and downside protection positions direct lending as a powerful diversification tool suited for all market environments, but especially unstable ones.

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Accessing the opportunity ahead

In our Direct Lending Outlook published in January 2023, we highlighted that the continued volatility in public markets has created meaningful opportunity in private credit. Blue Owl Co-Founder Craig Packer called today’s market one of the best investing environments for direct lenders, as banks remain unwilling or unable to commit to new financings. By providing certainty of capital to borrowers, direct lenders have been able to capture stronger protections and economics on new loans with banks largely watching from the sidelines. For investors, this translates to higher all-in yields and greater downside protection. Institutional investors have recognized the opportunity presented by this market, with a recent Preqin survey revealing that 83% of institutional private credit investors intend to make commitments to new funds in the first half of this year.12

As investors may consider options beyond the public markets in search of certainty for their portfolios, finding the right investment solution with an experienced partner is critical. Blue Owl’s market-leading direct lending platform brings scale, experience, and a strong track record to investors through innovative and easy to use fund structures designed to meet their needs. We believe a diversified portfolio must be able to provide consistent income, principal preservation, and hedge against volatility and inflation. Blue Owl’s direct lending strategies are purpose built to do just that – especially in today’s market environment.

 

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Past performance is not a guarantee of future results. The views and opinions expressed herein are those of Blue Owl and are subject to change as markets and other conditions fluctuate. Blue Owl is under no obligation to update or keep current the information presented.

Please see endnotes and important information at the end of this page.

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Endnotes

  1. Bloomberg as of March 1, 2023. Historical average inflation rate represented by all inflation data since reporting began in 1914. Recent peak as of June 30, 2022.
  2. Bloomberg as of March 1, 2023. Based on upper-bound of the median consensus estimates (Fed Dots) of the Federal Funds Target Rate.
  3. Bloomberg, S&P Global Market Intelligence as of December 31, 2022. Volatility is measured by the “VIX” which is the Chicago Board Options Exchange Volatility Index. It is designed to be a real-time estimate of the expected volatility of the S&P 500 and is calculated using the mid-point of S&P 500 (SPX) option bid/ask quotes.
  4. Bloomberg as of December 31, 2022. A hypothetical portfolio consisting of 60% equities represented by S&P 500 and 40% bonds represented by U.S. Aggregate Bond Index returned -16.9%.
  5. Bloomberg as of December 31, 2022. Bonds represented by U.S. Aggregate Bond Index, Equities represented by S&P 500.
  6. Cliffwater. “Direct Lending” represented by the Cliffwater Direct Lending Index (CDLI) as of September 30, 2022; Bloomberg. 3-month term SOFR (ticker: TSFR3M Index) as of 03/09/2023.
  7. Fitch Ratings Ultimate Recovery Rate Study, March 2022.
  8. Average annual loss rates since data for Cliffwater Direct Lending Senior Index began in 2011. Source: SP LCD, Cliffwater, JP Morgan. Market loss rates calculated as average loss rates and defined as: for loans, based on SP LCD default rates for all loan $ defaults as percentage of total outstanding and calculated as default*(1 – average historical Recovery Rate) from 2011 to December 2022; Direct Lending based on Cliffwater Direct Lending Senior Index realized gains/losses from 2011 to December 2022; High Yield Bonds based on JP Morgan Default Monitor annual defaults and calculated as default* (1 – average historical Recovery Rate) from 2011 to December 2022; Recovery rates for loans of range from 48-63% by year and 22-55% for bonds and are based on JP Morgan Default Monitor, February 1, 2022.
  9. Cliffwater. “Direct Lending” represented by the Cliffwater Direct Lending Index (CDLI), High Yield represented by the Bloomberg Barclays US Corporate High Yield Index, Traded Loans represented by the S&P/LSTA Leveraged Loan Index.
  10. Cliffwater. “Direct Lending” represented by the Cliffwater Direct Lending Index (CDLI) as of September 30, 2022; Bloomberg: “Equities” represented by the S&P 500 as of September 30, 2022.
  11. Data as of December 31, 2022 unless otherwise noted. Sources: “US Traded Loans” represented by the Morningstar LSTA Leveraged Loan Index, “US High Yield” represented by Bloomberg Barclays US High Yield Index, and “US IG Credit” represented the Bloomberg Barclays US Corporate Bond Index. “Direct Lending” represented by the Cliffwater Direct Lending Index as of 09/30/2022.
  12. Preqin Investor Outlook: Alternative Assets H1 2023.

Important information

Unless otherwise indicated, the Report Date referenced herein is March 31, 2023. Past performance is not a guarantee of future results.

The material presented is proprietary information regarding Blue Owl Capital Inc. (“Blue Owl”), its affiliates and investment program, funds sponsored by Blue Owl, including the Blue Owl Credit, GP Strategic Capital Funds and the Real Estate Funds (collectively the “Blue Owl Funds”) as well as investment held by the Blue Owl Funds.

The views expressed and, except as otherwise indicated, the information provided are as of the report date and are subject to change, update, revision, verification, and amendment, materially or otherwise, without notice, as market or other conditions change. Since these conditions can change frequently, there can be no assurance that the trends described herein will continue or that any forecasts are accurate. In addition, certain of the statements contained in this webpage may be statements of future expectations and other forward-looking statements that are based on the current views and assumptions of Blue Owl and involve known and unknown risks and uncertainties (including those discussed below) that could cause actual results, performance, or events to differ materially from those expressed or implied in such statements. These statements may be forward-looking by reason of context or identified by words such as “may, will, should, expects, plans, intends, anticipates, believes, estimates, predicts, potential or continue” and other similar expressions. Neither Blue Owl, its affiliates, nor any of Blue Owl’s or its affiliates’ respective advisers, members, directors, officers, partners, agents, representatives or employees or any other person (collectively the “Blue Owl Entities”) is under any obligation to update or keep current the information contained in this document.

This webpage contains information from third party sources which Blue Owl has not verified. No representation or warranty, express or implied, is given by or on behalf of the Blue Owl Entities as to the accuracy, fairness, correctness or completeness of the information or opinions contained in this webpage and no liability whatsoever (in negligence or otherwise) is accepted by the Blue Owl Entities for any loss howsoever arising, directly or indirectly, from any use of this webpage or its contents, or otherwise arising in connection therewith.

Benchmark definitions
S&P 500 Index: A stock market index that measures the stock performance of 500 large companies listed on stock
exchanges in the United States.

10-Year Treasury: The 10-year Treasury note is a debt obligation issued by the United States government with a maturity of 10 years upon initial issuance. A 10-year Treasury note pays interest at a fixed rate once every six months and pays the face value to the holder at maturity.

U.S. Aggregate represented by the Bloomberg Barclays US Aggregate Bond Index. This index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities, asset backed securities and commercial mortgaged backed securities.

Corp. Investment Grade represented by the Bloomberg Barclays U.S. Corporate Bond Index. This Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by US and non-US industrial, utility, and financial issuers.

Corp. High Yield represented by the Bloomberg Barclays US Corporate High Yield Index. This index measures the USD- denominated, high yield, fixed-rate corporate bond market.

Leveraged Loans represented by the S&P/LSTA Leveraged Loan Index. This Index is a common benchmark and represents the 100 largest and most liquid issues of the institutional loan universe.

Direct lending represented by the Cliffwater Direct Lending Index (CDLI). The CDLI seeks to measure the unlevered, gross of fee performance of U.S. middle market corporate loans, as represented by the asset-weighted performance of the underlying assets of Business Development Companies (BDCs), Including both exchange-traded and unlisted BDCs, subject to certain eligibility requirements.

All investments are subject to risk, including the loss of the principal amount invested.

These risks may include limited operating history, uncertain distributions, inconsistent valuation of the portfolio, changing interest rates, leveraging of assets, reliance on the investment advisor, potential conflicts of interest, payment of substantial fees to the investment advisor and the dealer manager, potential illiquidity, and liquidation at more or less than the original amount invested. Diversification will not guarantee profitability or protection against loss. Performance may be volatile, and the NAV may fluctuate.

This webpage is for informational purposes only and is not an offer or a solicitation to sell or subscribe for any fund and does not constitute investment, legal, regulatory, business, tax, financial, accounting, or other advice or a recommendation regarding any securities of Blue Owl, of any fund or vehicle managed by Blue Owl, or of any other issuer of securities. Only a definitive offering document (i.e.: Prospectus or Private Placement Memorandum) can make such an offer.

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