Welcome to Thoughts on the Market.
I am Vishy Tirupathor, Morgan Stanley's Chief Fixed Income Strategist.
I'm Vishwas Parker, Morgan Stanley's U.S.
Head of Credit Strategy.
While potential disruption from AI has been a key driver for markets, last few weeks the focus of investor agita has been in the software sector.
On today's podcast, we will talk about software in the credit markets and its implications.
It's Monday, March 2nd at 10 a.m. in New York.
Vishwas, let's start by understanding how the exposure in software manifests in the credit markets.
How does it compare to software, say, in the equity market?
Yeah.
So the software exposure in credit markets is large.
And understandably, that's why investors are closely watching what's happening with software in the equity market.
But what's interesting and important for investors to note is the exposure in credit is very different from what it is in equities.
So for instance, a good chunk of exposure in the credit market is around private issuers.
So we estimate about 80% of companies are private in the whole sample set that we looked at.
And that's largely a function of the fact that software is not a big part of the more liquid spaces, like investment rate and high yield, but it is heavily represented in the more opaque parts of the market, like leveraged loans, CLOs and BDCs.
So our analysis found that about 25 of BDC portfolios are in software, closely followed by private credit CLOs, and the leveraged loan market was about 16.
So that's an important distinction to keep in mind versus the equity market.
The second thing I would flag is because the software sector grew a lot in the loan market through the LBO wave of 2020 and 2021.
It has a weaker credit quality skew to it than the overall market.
So about 50% of borrowers in the sector are rated B- or lower.
So that's the lowest rungs of the sector. the rating spectrum.
Many of these software deals were underwritten with higher leverage than the broad market.
And, as a result of that, you also have more front-loaded maturities in the sector, which brings the risks of refinancing if some of this disruption persists.
But Vishy, that's a nice segue to you.
Over the past couple of years, you looked at the private credit market in depth.
And that's where I think the exposure to be found is the highest in BDCs, which is the public face of private credit.
So, in your assessment, what is the risk of software to private credit, given all of the headlines that are popping up?
Public ways of private credit, Mishwas, that's a great line.
BDCs business development corporations for those who are not familiar are companies that invest in the debt of small and medium-sized companies sourced through non-bank channels.
BDCs fund themselves through equity and debt issuance.
So if you look at the portfolios of BDCs to look at their exposure to software, there's a wide variation across the various BDC portfolios.
What makes the assessment of these software risks in BDCs challenging is that many of these companies are private companies without the reporting obligations of public companies.
So no earnings reports, no 10-case or queues or broadly publicly available financials to look at.
So, in effect, these companies need to be re-underwritten to evaluate which of these companies would be disrupted from AI and which companies could actually benefit from AI and see their margins expand.
So in the context of BDCs, liability spreads are something we are watching closely.
BDC liability spreads have widened, but we think more needs to happen there.
The clearing levels need to wait for the full resolution of the companies that benefit and that get hurt by disruption.
That is still awaited.
So we expect credit spreads of BDCs to remain volatile for some time to come.
So it seems like this is a significant, or at least a non-trivial, risk factor for credit markets, given the growth of the sector leverage, the skew and quality.
But Vishy, do you think this could be systemic for risk markets at large?
So I do think that this is a significant risk, but I don't think it's a systemic risk.
The amount of leverage in BDC is fairly small.
About 2x is the kind of leverage.
You compare that to the kind of leverage that existed in the financial system before the financial crisis that orders of magnitude smaller risk.
And also the linkage to the banking system comes through the back leverage provided to the non-bank lenders.
But this leverage is substantially risk remote with very high subordination levels.
So my conclusion here is this is a significant risk, but not a systemic risk.
So let me turn the same question to you, Vishwas.
Taking on a sort of historical perspective as well as a macro perspective.
How do you see this risk manifesting in the broader credit space?
Yes, I would agree with you, Vishy, that we need to see a valuation reset.
We think spread should go wider because of disruption concerns, even if they affect a relatively narrow part of the market.
But a lot of that's happening against issuance that's rising.
But I would say the risk of systemic concerns really emerging is relatively low.
If you look at historical cycles where credit has been the weak link in the economy, those are typically characterized by a lot of corporate re-leveraging.
So think about the late 1990s or from 2004 to 2007 or the early 2000 teens.
These are all cycles where corporates were being very aggressive, adding a lot of debt.
And when the economy slowed, credit became the source of some default and downgrade concerns.
We haven't really seen that type of credit cycle play out at all in the past few years.
If you look at corporate debt to GDP, for example, it's gone down each of the last five years.
Balance sheet corporate leverage has been flat or actually gone lower in spots.
MA activity, which is usually a good indicator of corporate aggressiveness, still remains below trend.
So I think we have had a fairly restrained credit cycle where in-place fundamentals are quite strong.
And that's why I think the systemic contagion from any credit spread weakness I think could be relatively muted.
So the key takeaway from us is that software and credit is a significant risk, but it's not quite systemic risk.
Thanks for listening.
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