As competition in the private credit market intensifies and the number of investable projects tightens, loan spreads for publicly traded credit funds continue to narrow, putting downward pressure on industry profitability. According to a report released on Monday by Raymond James analyst Robert Dodd, spreads on newly issued loans in the December quarter declined by approximately 0.15 to 0.25 percentage points compared to the previous quarter, falling to 5.23%. This trend highlights the large amount of capital chasing a limited pool of high-quality deal opportunities.
Changes in spreads reflect the supply-demand dynamics of the credit market. Over the past five years, investors have continued to inject funds into private credit funds, represented by Business Development Companies (BDCs), while the number of available private equity transactions for investment has remained largely flat. To compete for projects, credit funds have been forced to compress spreads and increasingly incorporate "Payment-in-Kind" (PIK) terms, where interest is added to the loan principal instead of being paid in cash.
Dodd noted that if spreads on new loans fail to rebound, the overall portfolio yield of BDCs could face further downward pressure as lower-spread assets gradually replace higher-yielding legacy assets. This is expected to weigh on industry profits and could persist until 2026. Data shows that among the publicly traded BDCs covered by Dodd, new loan origination saw a modest decline in the December quarter, while the use of PIK terms became more widespread. Currently, about 8% of new loans include PIK structures, significantly higher than the 3% seen in 2019.
This trend is particularly pronounced among large institutions, such as leading credit firms like Ares Capital Corporation (ARCC.US) and Blue Owl Capital (OBDC.US). As lower-yielding new loans replace older, higher-yielding ones, the overall portfolio yield of the industry continues to decline. Industry-wide spreads fell to 5.64% in the December quarter, down 0.34 percentage points from 5.98% in the same period of the previous year.
Specifically, the largest publicly traded BDC, Ares, reported an average yield on new loans of 8.5% during the quarter, significantly lower than the 10% yield on loans that were repaid or exited. Blue Owl Capital's new loan rate was 8.7%, down from 9.5% a year earlier, with the corresponding spread narrowing from 5.2% to 4.8%. Its overall portfolio spread also declined from 6% to 5.7%.
Analysis suggests that narrowing spreads, combined with a general decline in interest rates, will directly compress BDCs' ability to pay dividends. In fact, as the interest rate cycle peaks and begins to decline, industry dividends have gradually decreased from their highs, leading some investors to reduce their allocations to private credit assets.
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