Fed rate hikes threaten to further strain direct lenders as private credit default rates hit record highs.
The private credit industry keeps insisting it’s fine. The data keeps suggesting otherwise, and Wednesday’s interest rate hike from the Federal Reserve isn’t going to help the argument.
The Federal Open Market Committee officially raised the federal funds target range by 25 basis points to 3.75%-4.00%. The decision, which was unanimous among the 12 board members, marks the first rate hike since 2023.
“Whenever the Fed increases rates, the pressure on the liability side becomes very high,” David Yahalomi, chief operating officer and co-founder of Tel Aviv-based loan-management platform Hypercore, said in an email.
Companies that borrow through direct lending typically carry floating-rate debt, meaning their interest costs rise automatically whenever the U.S. central bank moves rates. The hike officially pushes up borrowing expenses at a moment when defaults are already climbing to levels not seen before.
“In the event of a prime rate increase, this structure shrinks [private credit portfolio company] margins,” Yahalomi added. And the squeeze is already showing up in the numbers.
Borrowers Buying Time
A Fitch Ratings report from Monday shows that the U.S. Private Credit Default Rate, or PCDR, hit 6.3% for the 12 months ended in August. That’s up from 6.1% in July. The rate has now held at or above 6.0% since April. Here’s the credit rating agency’s breakdown of the findings:
- Volume Surge: August logged 109 default events across 89 unique defaulters (up from 105 and 83 in July). The month alone saw 14 default events — a trailing-year high — driven by 11 new defaulters and three repeat offenders.
- Punting the Debt: Distressed maturity extensions made up 45% of August events (41% over the past year), while payment-in-kind (PIK) structures and interest deferrals represented 47% TTM. Hard payment defaults comprised just 8%.
- EBITDA Impact: Companies with less than $25 million in EBITDA posted a 12% default rate in August, though that’s actually down slightly from 12.3% in July. The bigger warning sign came from the $26 million-to-$50 million EBITDA bracket — Fitch’s largest cohort — where the default rate jumped to 5.2% from 3.9% in a single month.
- Sector Hotspots: Healthcare and industrials tied for the highest default rates at 9.9%, while consumer products ticked down to 8.7%. Software posted a default rate of just 0.6% in August. That’s down from 1.2% in July and 2.0% a year ago — the lowest of any major sector.
While the overall PCDR blends middle-market CLO ratings (MCO) and insurer-monitored private ratings (PMR), August’s rise was driven by record stress in MCOs (5.6%), even as PMR rates eased slightly to an elevated 8.5%.
PIK Portfolios Are Insulated — For Now
Suntera Fund Services
Harvey Tian, head of loan operations at Suntera Fund Services, said a size-weighted view changes how PIK interest should be read as well.
“Once the prime rate goes up, the terms on all the rates will increase, and it will definitely put pressure on the borrower side — the ones paying cash interest,” Tian told Global Finance on a call.
Loans structured with PIK options, however, aren’t paying cash interest at all, he noted. That insulates that particular pool of borrowers from a higher interest rate.
“I don’t see a huge effect on the underlying portfolio of PIK borrowers if it’s a one-time hike,” Tian said of Wednesday’s Fed announcement. A quarter-point increase would phase into the PIK rate structure over time rather than land all at once.
Multiple hikes are a different story, given the inflationary pressures caused by a worsening U.S.-Iran conflict.
Anthony Noto covers corporate finance and private credit. Contact him at anoto@gfmag.com.