Competition intensifies, overlay projects decrease, private credit spread continues to narrow Analyst: Industry profitability faces downward pressure

With the increasing competition in the private credit market and a tightening of the number of investable projects, the loan spread of publicly listed credit funds continues to narrow, putting downward pressure on industry profitability. According to analyst Robert Dodd of Raymond James in a report released on Monday, the spread on new loans issued in the December quarter last year decreased by about 0.15 to 0.25 percentage points to 5.23%. This trend highlights a large amount of capital competing for limited high-quality trading opportunities. The spread changes reflect the supply and demand relationship in the credit market. Over the past five years, investors have continued to pour funds into private credit funds represented by Business Development Companies (BDCs), but the number of private equity transactions available for investment has remained relatively stable. In order to compete for projects, credit funds have had to lower spreads, and even increase the use of "Payment-in-Kind" (PIK) terms, where the current interest is added to the loan principal instead of being paid in cash. Dodd pointed out that if the spread on new loans does not rebound, as low spread assets gradually replace high spread assets in the portfolio, there is still further downside potential for the overall investment portfolio yield of BDCs. This is expected to put pressure on industry profitability and may persist until 2026. Data shows that in the publicly listed BDCs covered by Dodd, new loan volumes in the December quarter last year showed a moderate decline, with a more widespread use of PIK terms. Currently, around 8% of new loans are using PIK structures, significantly higher than the 3% in 2019. This trend is particularly pronounced in large institutions such as Ares (ARCC.US) and Blue Owl Capital (OBDC.US) among other top credit institutions. As low-yield new loans gradually replace high-yield old loans, the overall portfolio yield of the industry continues to decline. Data shows that the industry-wide spread in the December quarter last year fell to 5.64%, a decrease of 0.34 percentage points from the same period in 2024. Specifically, the largest publicly listed BDC, Ares, had an average yield of 8.5% on new loans in the quarter, significantly lower than the 10% on already repaid or exited loans; while Blue Owl Capital had a new loan rate of 8.7%, lower than 9.5% in the same period last year, corresponding spread also narrowed from 5.2% to 4.8%. Its overall portfolio spread also decreased from 6% to 5.7%. Analysts believe that the narrowing spread coupled with a decline in overall interest rates will directly squeeze BDCs' dividend-paying capacity. In fact, as interest rate cycles peak and fall, industry dividends have gradually declined from highs, prompting some investors to reduce allocations to private credit assets.