The New Credit Order: Public Meets Private

EPISODE:

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VOICE-OVER: Welcome to Fixing Your Interest. In today’s episode, Lotfi Karoui, Multi-Asset Credit Strategist, and Co-Head of Client Solutions and Analytics, and Philipp Nowak, Credit Strategist, explore the shifting global credit landscape.

They examine the evolution of private credit; how to think about liquidity across public and private markets; and how AI‑driven disruptions are filtering through credit. They’ll explore the framework for navigating a more selective and differentiated credit environment, and where opportunities lie for investors.

PHILIPP NOWAK: Lotfi, welcome to London. Great to have you on the podcast.

LOTFI KAROUI: Thanks for having me. Great to be here.

PHILIPP NOWAK: Well, it's actually your first time visiting our London office since joining about, I think, two months ago now, right?

LOTFI KAROUI: Yep.

PHILIPP NOWAK: You're based in our New York office and you're in town because of a European investment summit that we actually just concluded yesterday. 400 clients attending, you know, an engaging debate and discussion for a full day. And you gave a presentation, which I thought was fascinating.

And so I think we want to use the next 20 minutes or so to unpack a couple of the points that you made in your presentation and really take it from there. And I think it'd be great to start with taking stock of where we stand year to date. In terms of credit valuations. So spread levels, yield levels, maybe you can weave in kind of the broader asset allocation context. A lot has moved, obviously, year to date, so I think that's a good point to start.

LOTFI KAROUI: Yeah, I mean, look, we're pretty much back to square one in terms of spread valuations, at least. But by and large, I think maybe with the one exception, which is the sterling market, but by and large spreads have pretty much completed a round trip. We're back to levels that are not too far relative to those where we started the year, which is interesting, right?

Because as you may remember, going into the year there was the strong view among investors that we got to get overall a friendlier sort of growth, inflation, and policy mix relative to what we had in 2025. So a nice sort of re-acceleration in growth in the US driven by, you know, fiscal impulse, easier monetary policy, and then subsiding sort of inflation pressures because the impact from tariffs would've been behind us.

Now, you fast forward almost four months later, you're exactly at the same valuation levels, so you're being paid exactly the same thing.

But I would argue that at least in the near term, the risk distribution looks very different from four months ago, you know, without taking a view on where the conflict is going to take us. But I think it would be a very strong assumption to make that, you know, the growth inflation mix would look as friendly as we had expected going into the year. So what does that mean to me?

It means that the market is telling you that it's willing to look through potentially a transitory period where that set of growth inflation trade-off looks a little less supportive than many had expected going into the year, which also means that policy on the monetary side will be a little bit more constrained, but the medium to longer term outlook remains pretty much the same, you know, still friendly and supportive.

Now there is also another element I think that matters when it comes to the conversation in credit, which is spreads are very expensive relative to their own history, but the level of yield support that you're getting in fixed income is still the best we've seen in probably two decades at least. And so this is still a good entry level if you look at fixed income and credit in particular as a total return product, in my view.

So you can buy high-quality fixed income in the dollar market at anywhere between five, five and a quarter, maybe even five and a half. In high yield, you're at anywhere between six and a half to 7%. Euro is obviously a little lower than that, but again, even relative to its own history, I think yields score very, very well.

PHILIPP NOWAK: Yeah, I think that's a very good point that you made. Yesterday at the summit, we asked the audience what is their main kind of rationale for investing in credit, right? We had answers like spread compression among them, but also yield and total return. And unsurprisingly, it was the vast majority was clearly focused on that yield element, which yes, the asset class brings to the table.

And I think that's indeed worthwhile keeping in mind if you think about starting yield levels as actually quite a good predictor of forward returns, at least in a historical context.

LOTFI KAROUI: Yeah. And in fact, I would argue what's been interesting is that there's a little bit of divergence too between bonds and risk assets. Because if you look at the yield curve, you haven't actually fully retraced that sort of premium built up that you had in March. I mean, there's some residual premium that's left out there.

And so that probably tells you that the bond market is a little more skeptical than the equity and credit markets when it comes to the prospects of a return to pre-conflict conditions. But you're getting the point is you're getting an even better entry point from a nominal standpoint relative to the start of the year today.

PHILIPP NOWAK: Absolutely. And I think there, you raised an important point. Equities clearly have also repriced, you know, very quickly. Moved on almost entirely from the conflict looking forward. So how do you assess just credit versus equities at this juncture?

LOTFI KAROUI: You know, again, it's a spread versus yield type of conversation. I certainly don't disagree with the vast majority of views that actually credit is very expensive relative to its own history. I mean, you can take a generic investment grade or high yield index spreads, and if you compare current spreads relative to the history of the last three decades, you are probably at the first or second percentile rank, meaning that you've only traded tighter than current levels 1% of the time going back to the last 30 years.

Same thing if you look at the equity market. You can take your favorite measure of valuations, whether it's an equity risk premium or cyclically adjusted PE, and it will look off the chart relative to a long history. So both are expensive. I think what you're getting in credit is, again, a better level of yield support relative to the equity market. But everyone has their own estimate of where the equity risk premium is.

Most people would say long-term equity returns in the US, at least, are anywhere between three, five, maybe 6%. Well, that's what you're getting by buying investment grade credit today. And if you want high yield, you know, you can get high yield that probably, you know, a little higher than that. So it's rare actually to see such an attractive value proposition of credit relative to equities if you purely looked at it through the lens of valuations.

PHILIPP NOWAK: Yeah, that makes sense. And maybe it's worthwhile for listeners just to put into context why are we so obsessed with that yield idea, right? If you're getting maybe an actively managed IG portfolio closer to 6%, in IG that gives you obviously a lot of buffer for things to go wrong. If you even have a spread widening, let's say of 50 to a hundred basis points or yields move, you'll probably in that scenario even still end up on a 12-month horizon.

LOTFI KAROUI: Yeah. And by the way, keep in mind that we had almost like a decade where the buffer was not there. Because policy rates were anchored either at zero or close to zero. Now you do have a buffer. I mean, you know, 10-year yields are, you know, four, four and a quarter. That's a pretty comfortable cushion against basically the state of the world in which you have some widening and then that negative correlation with yields kind of kicks in.

PHILIPP NOWAK: Yeah, that makes sense. Lotfi, let's pivot a little bit to the fundamental picture, 'cause obviously that is part of the equation ultimately that feeds into some of these valuations. What's your take? Where are fundamentals at currently in the corporate space?

LOTFI KAROUI: Yeah, look, I mean, if you go back and look at how the post-COVID expansion unfolded in terms of credit quality, I would say the one immediate observation I would make is that non-financial corporations on both sides of the Atlantic, whether you look at the US or Europe, have actually been a lot more conservative in the way they manage capital than governments and public balance sheets.

We've seen significant aging of public balance sheets across pretty much the entire DM space. On the corporate side, the mindset has been a lot more conservative, which is quite remarkable because we have to remember that corporate balance sheets have been under a lot of pressure actually since the start of the COVID recovery. You had pressure on margins from inflation back in '22 and '23.

So the concern back then was that this would erode pricing power and put some pressure on margins. Hasn't happened. Actually, most corporations exhibited remarkably strong pricing power and have been able to preserve those margins in the face of a pretty significant inflationary shock. And then we also had the most aggressive hiking cycle in probably 30, 40 years.

And so the cost of refinancing a marginal dollar went up quite dramatically in a very short period of time. And yet, if you take a snapshot of today's balance sheets, whether it's investment grade, high yield, Europe versus the US, what you see is that pick any of your favorite measure of net leverage, it's been flat over the last couple of years. So that is good.

There's been some deterioration in interest coverage ratios, which is understandable because every new dollar that you refinance costs you more. And so whatever you issued in 2020 when rates were at very low levels, now you have to pay a little bit more to refinance that. But the absolute level is still pretty healthy by historical standards.

And then margins have been stable in Europe and they've continued to expand in the United States. And so profitability is still pretty much flashing green here. So I think fundamentally on the public side, I would probably say it's an A to an A minus.

PHILIPP NOWAK: Right. So, and I think you raised an important point here, the public side of the equation, right? We're seeing headlines, and so maybe that's a good segue to actually pivot, 'cause if you open the Financial Times today, there are constant headlines that there are cracks appearing, you know, talk about cockroaches and coal. So maybe let's pivot to private markets a little bit. Where do you see cracks appearing?

LOTFI KAROUI: I mean, look, it's certainly been headline-grabbing for sure, and not a week goes by without seeing a new headline about redemptions and cockroaches and defaults and losses and things of that sort. I really think it's important to frame the debate here and try to say, okay, look, what are the risks? What are we talking about here?

Are we talking about a threat to financial stability on the back of rising financial distress in direct lending, in private credit? Or are we talking about cyclical risks? If the concern is that the current situation would morph into some kind of a systemic shock, I would take the benign side of that debate. I don't think this is a systemic problem in a sense that it would pose an issue to the viability of the financial ecosystem.

There's a lot of differences in my opinion between the current situation and the run-up to the global financial crisis. But I'll give you two key differences. The first one is private credit is not a leveraged asset class. There's a little bit of leverage, of course, to improve returns, but it's nothing compared to the type of structures that were prevalent in that 2006–2008 period.

There aren't really pronounced mismatches in terms of liquidity or assets and liabilities. We will probably talk about the growth of semi-liquid funds, etc., but they're semi-liquid, they're not liquid. And so the bulk of the capital is actually sitting in vintage-type funds. It's locked-up capital. And so the idea that you can have a fire sale of assets on the back of mass exit is also quite limited, in my view.

That was a key contributor to what made the financial crisis what it is today. Now, of course, never say never, you could always describe a state of the world in which this becomes a bigger problem and a threat to financial stability, but I think the odds are fairly low. Now, are there fundamental problems?

Yes, absolutely. And the first thing I would say is that we should not conflate direct lending with private credit. You know, private credit is a much bigger, broader asset class. Direct lending is a subset of it. It is true that it has been, up until recently, the primary growth engine of private credit.

And so it comprises the biggest bucket within the broader private credit universe. What are the challenges? A couple of challenges. One, I think we had some loosening in underwriting standards.

And so the growth of the asset class has generated imbalances. And I'll give you one example. If you look at European direct lending and you use a very conservative estimate, the total AUM was a little less than 50 billion in 2015. Well, 10 years later, we're close to 350 billion. So that's like 7x growth in a decade.

Every time you have that type of growth, you're prone to imbalances, basically too much capital, not enough assets where you can deploy that capital. That generates borrower friendliness, and it erodes the premium that you're getting as an investor to deploy that marginal dollar into direct lending. And so if you look at the average spread on new deals in direct lending, they've been steadily compressing over time.

And actually, if you scale that by things like balance sheet leverage, what you immediately see is that your compensation relative to public credit is actually de minimis.

And so there's been steady erosion in the compensation and also some loosening in underwriting standards. So that's problem number one. In the United States, there's another issue, which is the strong sector concentration in software. Obviously that's a technology shock. It's probably not cyclical in nature.

But again, if you take BDC portfolios as a rough proxy for what the broader direct lending market could look like, the share of software is north of 20%. And there's quite a lot of variability across portfolios. Some portfolios have a 40% share, others have a lower share. And so that's an issue because there's a lot of question marks today around the terminal value of those businesses, the risk of displacement by AI, etc.,

Now, luckily, refinancing needs in software are actually quite benign in the near term, and so there's no imminent cliff that would cause a rise in financial distress.

But in a world where capital is leaving the asset class, obviously we're seeing a lot of redemptions. And so that means financing conditions are tightening on the margin. Yeah, I think when the time comes to refinance those capital structures, some of that refinancing will be taken care of in the form of balance sheet restructuring, etc., , because for a lot of these capital structures, current funding costs are just not acceptable or not something that they can tolerate if you want to put yourself on a sustainable basis.

So it is an industry shock that is in some ways reminiscent of what the high yield bond market in the United States went through back in '14 and '15 with energy. Every time you have these industry shocks, eventually it ends with defaults, losses, restructurings, and then you kind of start over again.

Now the third issue is obviously question marks about the marks, for lack of a better word. That's a bigger and probably a topic for a much longer conversation. But certainly if you walk in the shoes of an investor in a semi-liquid fund and you basically see software stocks down 25%, 30%, you see software broadly syndicated loans that are down six, seven points, you start asking questions about where the marks are on the private side.

And I think that explains a little bit the pressure that we've seen on redemptions. That's a little bit of a wake-up call, I would say for a lot of folks because you have to ask yourself, I mean, there's nothing wrong in the structured private markets as long as they're giving you the right compensation for illiquidity. And I think what we've discovered is that over the last few years that compensation has eroded quite dramatically.

PHILIPP NOWAK: Yeah, and I think maybe to briefly follow up on that point, you had a really great chart in your presentation with regards to marks. The traditional direct business was one lender, one borrower. Now as the market has grown and there are multiple lenders chasing the same type of deals, maybe briefly elaborate on the chart.

LOTFI KAROUI: Yeah, no, thank you. I mean, look, the structure of direct lending up until probably 2022, I would say, was really a single borrower, single lender type of structure. So one loan would be underwritten by one lender to one borrower. That actually at the time meant stricter controls, better covenants, better oversight.

And probably if we had a default cycle back then, I'd say direct lending would've probably done better than public markets, because you do have that special relationship between lenders and borrowers. That has changed over the last couple of years. And so what we've seen is really growth of these large or jumbo deals that are underwritten by multiple lenders. And that creates frictions, right? And so one of the frictions is disagreements over the marks.

And so the chart that you're referring to actually shows, the price range for those loans that are held by more than one BDCs and sort of the difference between the most optimistic manager and the most conservative one. And that differential has increased quite dramatically over the last couple of quarters.

That's not helpful. Basically, if you're an investor because you're like, okay, why aren't the marks where they're supposed to be? There could be some difference. Obviously, these are privately, you know, lows. There should be a little bit of differences of opinion, but not to that degree.

PHILIPP NOWAK: Yeah, that makes sense. And maybe to put things into context, 'cause you said software was in direct lending space quite large exposures at times, and that's probably the sector where we see most cracks, at least being priced by the market right now.

Could you just briefly put it into context as well? 'cause you talked about the strong fundamentals in public high yield, public IG where it's actually less of an issue, so maybe you can put some numbers on it.

LOTFI KAROUI: Yeah, yeah. And by the way, the risks are also dramatically different. I think the conversation in leveraged finance, but not just in direct lending, but also the broadly syndicated loan market is really a lot more focused on AI disruption risk. I think the conversation in investment grade is a lot more focused on AI CapEx risk. But obviously the CapEx needs of the hyperscalers are very significant.

If you take consensus expectations as a benchmark, we're expecting a trillion and a half of CapEx in '26 and '27, which is a significant number. I think what you've seen over the last year and a half is a clear shift in the financing or funding mix of that CapEx.

I think earlier on there was strong reliance on internal cash flows to finance that. But we got to the point where today, or in 2026, CapEx is expected to absorb over 80% of cash flows from operations.

And so what we've seen is a shift, which is natural, to debt markets as a way to finance a portion of that CapEx. So the concern that you probably heard all the time is this the late 1990s all over again, you know, are we using debt markets aggressively to finance CapEx? I don't think this is the late 1990s.

I mean, if you look at the hyperscalers and tech more broadly in the investment grade market, it still remains by far the least leveraged sector. When you look at the broader non-financial universe in investment grade. And don't get me wrong, the releveraging impulse is real.

There has been some releveraging over the last couple of quarters, but off of a very, very low base. And so to me, there's plenty of debt capacity that's still left in the tech sector.

And let's not forget that this also remains the most profitable sector among non-financials. And so back in the 1990s, you actually had a cohort of companies that were barely profitable, maybe sometimes unprofitable, that were relying on debt markets. This is not what we're seeing in the investment grade market today. And so there's still a lot of room, I think, to utilize that.

Now look, is it possible that at some point the equity market starts asking questions about where is this CapEx going? What are the returns on equity? Absolutely. But I wouldn't take a shortcut and say that that will be a problem for bondholders too. I think the bar is a lot higher than most people think.

PHILIPP NOWAK: Yeah, that makes sense. You mentioned illiquidity premium have clearly compressed as more capital has chased the deals. I want to expand on that a little bit and maybe pivot also to the public markets. There's a debate out there that you see convergence in liquidity, that private debt is tradable, which probably we wouldn't necessarily underwrite from a PIMCO perspective. So maybe dive a bit deeper.

LOTFI KAROUI: Yeah, I mean, it's interesting because convergence is a word that means different things to different people. But if by convergence we mean convergence of secondary market trading, I think that's clearly not happening. I mean, actually, if you look at liquidity conditions on the public side, and again, we're lucky that in the US we have good data.

We have transaction-level data that we can track exactly the health of liquidity conditions in the corporate bond market. I would say unquestionably, it's actually the healthiest it has been since the end of the global financial crisis.

And you can see that across a variety of metrics, whether you look at market depth, you look at market breadth, you look at transaction costs, everything is scoring very, very high relative to the history of the last 20 years, actually even in the high yield market.

If I look at the turnover on small capital structures, these were very illiquid a decade ago. Now actually, they enjoy much better liquidity. Why has that happened? There's been significant improvement in terms of the plumbing or the technology of the market, and so portfolio trading, the growth of risk management tools for managers in the space, things like total return swaps, et cetera.

So I think that's created a better continuum of prices and a more robust price discovery process on the public side. Now, can we replicate that on the private side? Can we trade loans line item by line item? I'd be very skeptical. Number one, the appeal of direct lending and private markets in general is actually their illiquidity premium.

So if you start trading them, that defeats the purpose a little bit. What are you getting as compensation? And then more broadly there are a lot of constraints on your ability to really have proper two-way flow trading as opposed to sporadic trading. You have to create a more diversified investor base.

There's some infrastructure that you need to build around. And now the argument that you sometimes hear is that, well, look at the broadly syndicated loan market, it became a liquid market. Sure, it did become relatively liquid, because it's still less liquid than the high yield bond market, for example.

But a lot of heavy lifting has happened to allow that, most notably the growth of a diversified investor base, the putting in place of some pretty good infrastructure around it, et cetera. So I think that conversation, in my view, is a little misguided.

PHILIPP NOWAK: That makes sense. Now, I'm taking a look at the watch and we have to start unfortunately slowly wrapping up. We're probably going for now. But I want to ask you one more question.

If you think about the full spectrum on private and public markets, and you could pick any asset class you want in any sub-asset class, where would you currently put your money and where would you probably be a bit lighter in risk?

LOTFI KAROUI: Yeah, I mean, within high-quality fixed income, I would say agency mortgages in the United States are still pretty attractive. I mean, they've tightened actually in terms of spreads quite a lot over the last couple of quarters. But I still find it quite remarkable that this is a AAA asset class that actually offers you a spread that is wider than investment grade credit.

Now, there are reasons for that. We can have another podcast and talk about why agency mortgages are structurally cheap, but as a source of excess carry, I actually think that offers quite a lot of value.

PHILIPP NOWAK: And extremely liquid as well.

LOTFI KAROUI: Yeah, it's actually more liquid than corporate credit, if anything. That's a great point. I think structured credit is still offering, again, it's a relative game. Everything is tight across the board, but relative to plain vanilla bonds, I think you're still picking up some interesting excess premium there.

And I really think actually the opportunity set is at the single-name level. I mean, we had a decade where it was hard to be an active manager and actually beat your index.

Now this is your opportunity basically to shine, I think, because if you look at the index, as we started the conversation by saying that we're back to square one, sure, that's true at the index level. Scratch under the surface and look at dispersion, it's actually higher today than it was back then. And so I think this is one of those markets that doesn't really reward you if you are pursuing a passive strategy and just naively buying the index.

But there's plenty of opportunities at certainly the sector level, but also the single-name level. So you're rewarded to do the work in this market in a way I think that you haven't been in a very long time.

PHILIPP NOWAK: Yeah. Selectivity really matters here.

LOTFI KAROUI: Yeah, absolutely.

PHILIPP NOWAK: Well, Lotfi, thanks so much for coming on. We'll certainly have you back when you're in town again. Fascinating discussion. Thanks to all of our listeners for joining today. If you have not subscribed to the podcast yet, please do so now. We have lots of great content coming out over the next couple of weeks. With that, we'll wrap it up. Thanks so much again.

LOTFI KAROUI: Thank you.

VOICE-OVER: Thanks for joining us on Fixing Your Interest as we explored the themes driving global credit markets today and in the period to come.

Stay with us as we continue to navigate the challenges and opportunities across the investment landscape. For deeper insights, analysis and resources, visit PIMCO.com

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