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In this episode of Syndicated Nation, senior reporter Sunny Oh welcomes Lotfi Karoui, managing director and multi-asset credit strategist for Pimco, to discuss how corporate credit has managed to hold up in the face of geopolitical jitters from the Middle East and worries around the terminal value of software businesses.
Karoui also addresses the relative liquidity between direct lending and 144a private placements — often conflated with private credit — the growing dispersion of loan marks in business development vehicles, and questions around whether public bond markets can absorb the flood of data-center-driven issuance spurred by hyperscalers’ AI spending.
Have any feedback on the podcast? Send us a note at podcast@9fin.com — thanks for listening!
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Sunny Oh
Hello everyone, I'm Sunny Oh, Senior Reporter for 9fin, and this is another episode of the Syndication Nation podcast, where we cover all things leveraged finance. Today, we have Lotfi Karoui in the studio. He recently joined PIMCO after an 18-year run at Goldman Sachs, where he most recently served as Chief Credit Strategist at the bank. Welcome. Thanks for having me. Yeah, so just to get us started, talk through your first few months as PIMCO's new multi-asset credit strategist, and what you've been up to today. What you've been up to so far, just in case the audience aren't too aware of your own reputation.
Lotfi Karoui
Yeah, I mean, look, we're always driven by the news flow on the market side, and needless to say that the last two months have been very interesting. I mean, when I joined early February, back then the conversation was all about AI capex, and then it morphed into AI displacement risk. We had the sell-off in software loans. Then we had concerns about private credit, and then to finish, we're trying to figure out whether the ongoing conflict in the Middle East is going to morph into a full-blown supply shock in the energy market. So it's been nothing shy of interesting and volatile, which is always a good environment for us.
Sunny Oh
Yeah, no. And I just heard you just came back from Europe, so obviously the Iran conflict is very topical. Just talk through what you were hearing back from your clients there. What was top of mind?
Lotfi Karoui
Yeah, good question. Look, I think most people have been surprised by how risk assets have behaved actually throughout the episode. But obviously, we've completed a round trip, and in some pockets, we're actually even higher than the levels that prevail pre-conflict. And so as a modal outcome, risk assets are essentially pricing in not only a full return to pre-conflict conditions, but also an economy that will be able to sort of absorb whatever shock we'll have. That's something that surprised a lot of folks. And the two big questions are really, what are the tails around that modal outcome?
Question number one, is this 2022 all over again? And are we a little bit too complacent about that? If you remember in 2022, on the back of the Russia-Ukraine conflict, we also had a shock in the energy market. That shock pushed central banks to err on the hawkish side. And most investors ended up suffering a double whammy of higher yields and lower risk assets. And so that's one concern that we're hearing all the time.
And I guess the other concern is, what if this is not 2022? But rather than this shock sort of becoming stagflationary in nature, what if it ends up morphing into a full-blown growth shock and a recession maybe? So there's concern definitely about the cyclical outlook here too.
Sunny Oh
So given those tail risks, are you impressed by the just general resilience of risk assets in general?
Lotfi Karoui
Yes. It has been very impressive. And by the way, it's been also, that resilience has been visible across the board. I mean, you look at the equity market, but look at corporate bond spreads. I mean, we're basically only a handful of bps — if I take investment grade on high yield, we're a handful of bps above the levels that we started the year with. And those levels were very close to all-time tight levels. So yes, it has been quite impressive.
I think where there's been another debate is, okay, if you actually looked at the rates market, it's kind of telling you a slightly different story, but pick your favorite point of curve, whether it's two-year yields, five-year yields, 10-year yields. We're still above, actually, you know, the levels that we went into when the conflict started. And so there's a little bit of a residual risk premium there. And so that's been a little bit puzzling for people.
In my mind, you know, the two markets are actually, whether you look at risk assets or government bonds, they're both pricing in the same modal outcome, which is really a mild stagflationary shock that is unlikely to sort of derail the economy and, you know, trigger a recession. And so risk assets are telling you, okay, I am willing to ignore that and cut through that noise as long as I still have faith in the durability of the cycle and I'm willing to look at other tailwinds for the economy, whether it's AI CapEx, the strength of earnings, etc.
I think the rates market is telling you that I have to pay attention to the fact that now, at least in the near to medium term, central banks are going to be a little bit more constrained in their ability to ease. And as a result of that, I need to demand a little bit of an extra risk premium. And so to me, it may seem puzzling on surface, but actually you can rationalize it a little bit and you can sort of tell the story as to why there's some residual risk premium in the bond market and not in risky assets.
Now, is that residual premium attractive? I would argue yes. I mean, I think the bond market is kind of paying you to hedge against the state of the world in which this morphs into something bigger and ends up posing a threat to the durability of the cycle. So actually at these levels, I would say we generally like duration, you know, particularly the five-year point of the curve.
Sunny Oh
Okay, interesting. So you don't necessarily see the way risk assets have performed as a story about investor behavior. Some might suggest that for investors who shifted into cash, turned away from markets, were only punished by their performance, right? You know, it didn't pay to be in cash.
Lotfi Karoui
Yeah. And look, I mean, I'm not dismissive of positioning and technicals. There's no doubt that you can also tell a very different story, which is investors went into this with sufficiently high cash balances. And so positioning was kind of clean. And then that excess liquidity or excess cash got redeployed fairly quickly once it sort of became clear that the asymmetry was skewed towards some form of resolution. So I'm not dismissive of that, but all I'm saying is that if you put on like a fundamental hat and sort of ignore positioning and technicals, you can tell a fundamental story about this. Like it still makes sense. It does still, yeah, it does make sense to me.
Sunny Oh
Okay, interesting. So just shifting tack, like in your commentary, you know, you've been focusing a lot on the relative liquidity between different asset classes and corporate credit. So you've compared like true private credit assets like direct lending to 144A private placements, which you argue are much more liquid. So just talk us through that because there's been some recent transactions, especially these data center bond offerings, Meta, Oracle more recently. The depth in liquidity has clearly been shown. So just walk us through that.
Lotfi Karoui
Yeah, I mean, we really try to make a very simple point, which is if you're trying to say that private claims are liquid, don't use 144As as an illustration of that liquidity because 144As are not like, you know, private claims. So actually, as you know, some of our listeners may know, but in June of 2014, 144As started to become TRACE-reportable.
And so, you know, if you execute on a trade, you know, involving the 144A bond, you had to report that on TRACE. And that introduced dramatically better transparency. It strengthened the price discovery process. And it also was almost like a textbook example of kind of demand creating its own supply a little bit. So if you look at the composition of the high-yield bond market today in the U.S., the overwhelming majority of the bonds outstanding are actually 144As.
And so it was a good example of a win-win. And issuers like it because, you know, it gives you flexibility. It gives you probably a better certainty of execution. You can go and issue a bond and then you're done very quickly. You minimize them frictions and costs, et cetera. And then investors also liked it because they're not actually giving up in terms of on price discovery or anything like that. You can actually see exactly where the trades are printing. But that's not private credit.
Sunny Oh
Right, yeah.
Lotfi Karoui
That is not direct lending. I guess for direct lending portfolios, the price discovery, and I actually happen to think that because the price discovery process is not as good, and that's probably an understatement as public markets, that also explains why we've seen all these pressures on redemptions. But I'll give you one simple example.
And I think we also have to be humble a little bit when we talk about private credit because the vast majority of assets in private credit actually sit in drawdown or vintage funds. They don't sit in semi-liquid structures or like non-traded BDCs. But if you take BDC portfolios as like a rough proxy for what direct lending could look like, what you see there is that actually the marks are sort of all over the place a little bit. There's a lot of dispersion in the marks for those loans that are held by more than two BDCs. On our estimates, the price range between sort of the most conservative and the most optimistic call it manager is over five points. You never see that on the public side.
Sunny Oh
Yeah.
Lotfi Karoui
So part of the, you know, I think part of the anxiety that you're seeing, you know, that's fueling redemptions is really this idea that on the public side, the price is the intersection of supply and demand. It's unique. Like you can pull any bond, right? Go on Bloomberg and you'll see like one price. You don't have that on the private side. And so I think we need to figure out a solution to improve price transparency where it's okay to have a disagreement about the marks. That disagreement can be half a point, a point, maybe a point and a half, can't be five points.
Sunny Oh
Although some may argue the point of this is that it's very hard to mark this stuff.
Lotfi Karoui
Yeah. No, I'm not. It's not an easy fix. Right.
Sunny Oh
It's not an easy fix for sure. Sure. And so, you know, talking about those BDC marks, it's definitely a topic of discussion. You know, how has that dispersion changed over time? Has it really picked up this year? Like in your sense?
Lotfi Karoui
Dispersion in the marks? Yeah. It's actually picked up over the last, you know, two to three quarters. Yes. And it kind of makes sense. You know, when uncertainty is up, there's more disagreement, I guess, among managers too.
Sunny Oh
And how has this shown up in something like sort of the relative performance between BDC bonds and BDC equity?
Lotfi Karoui
That's actually a great question. That's somewhat of a different conversation. I think the equity conversation is really, you know, a nav uncertainty story. And maybe I'll point out to what we went through back in 22, 23 in the real estate market as kind of a template of what that happens.
But, you know, when you have uncertainty over the marks, the equity wrapper around the BDC tends to respond first. And we saw that back in 22 with public REITs dramatically underperforming. Private REITs, again, if you measure the performance of private REITs using, you know, the marks, you know, public REITs tend to react very quickly and apply a large discount to, you know, that uncertainty.
And then over, I guess, a year and a half period, they kind of both reconverged a little bit and met halfway. My guess is that something like that will likely happen, you know, for BDCs too, where, you know, right now, if you looked at on average, price to book on publicly traded BDCs is probably around 0.8. And so the discount is close to 20%. My guess is that we're going to reconverge over time where the marks are going to go down and then the equity is going to go up and they'll probably meet in the middle exactly like what we had back in 22, 23 with public and private REITs.
Sunny Oh
Gotcha. Okay.
Lotfi Karoui
The bond story, because you asked me about credit. I think the bond story is a little different in my view. I think, you know, what bond investors priced in back in February and until maybe early March is really the risk of rapid deterioration in asset quality; spreads widened out.
At current levels, I would say if there's another leg wider, it'll probably have to be driven by concerns over liquidity. But the asymmetry does look probably compelling, you know, on the bond side, certainly more so than on the equity side. And, you know, in my opinion, I think the risk that this escalates into a liquidity problem, while you can never rule that out, of course, but that seems to be pretty low at the moment.
Sunny Oh
And is that argument also contingent on sort of where you sit on the relative cap stack? Because I know that lenders I've talked to in that space, they like being senior. Of course. I mean,
Lotfi Karoui
by the way, again, what we went through in the real estate market back in 22, 23 offers you a very good template. Back then, it was good to be a lender because if you're a lender, the fact that you own the equity too. Yeah.
Sunny Oh
Got it. Got it. So, you know, maybe this is somewhat related is that, you know, there's been a lot of conversation about the software sectors. And, you know, that can be sort of seen in the BDC marks where we've seen some of these software loans. There's been a quite a bit of dispersion just made partly because like some of these loans have not performed as well as people have hoped.
You know, in your own analysis, you've mentioned that the sponsor put for some of these companies in general has been sort of fraying. You know, it's not quite there. You know, what do you think lenders are asking themselves when they see that? Is, are they genuinely questioning that the sponsors are no longer willing to put in equity to get these, to buy these issuers some more room? Because, you know, there's the big question, the 2020 maturities.
There's going to be a lot of amend & extend. And for the large lenders we talked to, the price seems to be the sponsor to kick in some equity, just to kick the can down the road. But there's a lot of questions around that, you know, is there enough dry powder to have-
Lotfi Karoui
To allow everyone to refinance.
Sunny Oh
Yes.
Lotfi Karoui
Yeah. I mean, great question. I actually think those two headwinds sort of feed into each other in some ways.
There is no question that there's strong sector concentration in direct lending portfolios. Again, if you use BDC portfolios as a rough proxy, what you see is that the share of software is above 20%. So it's pretty high.
And obviously, you know, to your point about dispersion, a lot of dispersion across managers. For some managers, it's a lot higher than that. For some managers, it's lower than that. That's bad news. I mean, no one could have predicted two years ago that the software industry is going to be vulnerable to the risk of AI displacement or AI disruption. And so that does create serious fundamental challenges because the number one question is, what is the terminal value of those businesses?
Now, if you take clues from the equity market, what you see, and granted, those are the universe that trades in the S&P 500 is very different from the universe of issuers that you see in direct lending portfolios. But nevertheless, there are similarities. If you look at the equity market, there's been a quasi-permanent derating of the valuation on software. I think you'll see something like that happening in direct lending too. But that question about the terminal value of those businesses is something that I think will continue to haunt investors for quite some time. So that's problem number one. Your second question is, obviously, direct lending is dominated by sponsored firms or PE-owned firms.
You know, I'd like to go back to the COVID episode to sort of understand differences between that and today. Back when we had the COVID shock, actually having a sponsor was a good thing from the borrower's perspective because an investor has actually rewarded companies that were owned by private equity firms. And the thinking back then was that if you were owned by a PE firm, you had funding backstop, you had liquidity backstops, and so you had sort of more optionality or more flexibility in the way you manage your capital structure. That perception seems to have eroded today.
And actually, if you look at the performance of PE-owned loans, loans issued by PE-owned firms versus those issued by publicly listed firms, you know, publicly listed firms have actually done better, even if you account for compositional differences between the two universes. So you make that comparison very carefully and you still see that. You know, that tells you that sentiment that basically vis-a-vis sort of, you know, the PE ownership has definitely shifted this time around. Look no further than the performance of, you know, private equity in the equity market.
And it's sort of, you know, it explains everything in my view. And so the value of that put has eroded. Can it come back? You know, time will tell. But I think the question that investors need to answer is, what is the terminal value around those businesses? And I think once you have clarity on that, sure, I think it can come back. But at the moment, it feels a little tough.
Sunny Oh
And so on average, what did that sponsor put actually look like pre-SaaSpocalypse, you know, before all the software issues came to light?
Lotfi Karoui
Well, you know, so it's value kick in when you need it, you know. And, you know, when the market operates normally, you just barely see it. But during COVID, you know, think of my memory serves me well. What we saw is actually, particularly, you know, in the high-yield bond market, you know, for those LBO situations, you know, a triple C bond issued by a PE-owned company widened dramatically less than a similarly sort of rated bond issued by non-PE companies.
Now, obviously, we have to be a little humble, too, because the COVID shock was very unique in nature. It was short-lived, and it was followed by a spectacular policy response, both on the monetary and on the fiscal side. And so no one really knows whether that sponsor put would have been, you know, would have persisted, you know, had the shock sort of lingered for another, you know, two to three months.
But if you take that for what it's worth and you say, okay, I'm going to zoom in on that period and see, you know, how the sponsor put did, the sponsor put actually was there. That wasn't the case this time around. And so that's sort of the difference that I would point to.
Sunny Oh
And I guess this time around, the U.S. economy is in much better
Lotfi Karoui
place. Exactly. Spreads are a lot tighter than they were back then. There's always uncertainty, but there's less uncertainty over the forward path in the economy, etc., etc. Absolutely. Yeah. Now, that maybe highlights another difference, which is the software story is an industry story. It's not a macro shock to begin with.
To me, it is reminiscent a little bit of what we experienced over 10 years ago in the high-yield bond market when we had the onset of the shale revolution. You know, it was pretty somber. I mean, as you may remember, you know, energy was roughly 15%, 16% of the high-yield bond market back then. We figured out ways to extract oil that were cheaper, and that ended up creating winners and losers in the industry. But, you know, there were more losers in the high-yield market than winners, and the way that story ended is with, you know, a surge in defaults and very low recoveries in the oil and gas sector.
Sunny Oh
And I guess a permanent change of behavior, right?
Lotfi Karoui
Very interesting point, not only on the investor side, but also on the issuer side. As a result of that, actually, most shale companies were managing capital in an incredibly conservative way. And I think, actually, if you look at the performance of the energy sector in high-yield today, it's one of the, I think it's the tightest sector, actually. It trades at incredibly tight levels. It's done very well year-to-date. Some of it, obviously, can be explained by the price action in the oil market. But I think a lot of it, to your point, is actually a change of behavior. It's the fact that, you know, managements are, you know, perceived to be bondholder-friendly and quite conservative. And they're not, you know, they will resist sort of the attempt to, you know, increase CapEx in order to pump more oil because they learned the lesson from that 14, 15 episode.
Sunny Oh
Yeah. And it's been kind of amazing to hear them sort of ignore that mantra of like, right? Yeah, yeah, yeah. Right? Like, you know, they're just a different new
Lotfi Karoui
breed here. The fact that, you know, oil prices are above, you know, crude is above whatever, 70 bucks for, you know, six months is not a good reason for me to go and spend like crazy on CapEx.
Sunny Oh
Yeah, exactly. And I guess we've been hearing that from the management teams. Yeah, yeah. So it's been a fascinating one to watch. Just turning to sort of the broader economy, you know, I think you and your previous commentaries have noted, and I don't think it's a theme unique, particularly unique to anyone, is that, you know, we've seen this K-shaped economy, right? And we've seen this sort of mirrored in corporate credit.
Lotfi Karoui
Yeah.
Sunny Oh
You know, talk us through that, because, you know, are you seeing just this real strength in performance of like double Bs spreads wise and sort of the triple Cs really underperformed? Like, you know, how do you see that? Because I think it's an ongoing trend, right?
Lotfi Karoui
Yeah. I mean, it's been a story of the haves and the have-nots. And so obviously the K-shaped economy and the consumer side is something that's been sort of well-documented and well-commented on. We're seeing, I would say, a mini version of that in the corporate world. And I think the reason is that, you know, you go back to 2022, you had probably the most aggressive reset in funding costs in 40 years.
Sunny Oh
Right. Right.
Lotfi Karoui
As a response to sort of that unfavorable trade-off between growth and inflation. At the same time, you know, those triple C capital structures were actually built in a world where the risk-free rate was almost zero. And so you had basically a lot of capital structures that were not built for a world in which the terminal value of Fed funds rates, pick your number, three and a half, three and three quarters, whatever that number is.
And so it doesn't work, basically, you know, given the reset in funding costs. That explains to a large extent where we've seen this boom in liability management exercises. It's been a very gentle default cycle, to say the least. I mean, I wouldn't even describe it as a default cycle in the sense that you didn't see a super spike in, you know, in defaults with sort of your annual default rate going to double digit levels. But what you've seen, however, is a surge in LMEs.
I mean, you know, distressed exchanges or liability management exercises accounted for the vast majority of defaults year to date. A lot of that reflects the desire of those companies to try to put themselves on a sustainable path from a funding standpoint. But they went through a massive funding shock and rates are not coming back to where they were, you know, pre-COVID and then post-GFC. And so you continue to see that until you get to sort of a place where, you know, you can kind of survive. But that's, and the same thing is true on the consumer side.
Sunny Oh
Right.
Lotfi Karoui
It's really a cost of funding. I mean, it's an affordability issue. Sure. But you sort of built a household capital structure that just cannot operate in this environment.
Sunny Oh
So how do you see the health of U.S. households at this point? You know, because it's, I think, up to now, it's been quite actually very resilient. Household debt is relatively low.
Lotfi Karoui
It's very low. Very low. I mean, that's kind of the paradox a little bit where if you look at aggregate data, you can pick any of your favorite, you know, household balance sheet metrics and it would look amazing. Right. You know, debt service ratio, whatever you want to look at, it will probably look at its healthiest level in over 25 years. You know, the issue shows up once you start disaggregating the data a little bit and you look at that low end of the income distribution, it doesn't look as good, basically.
I mean, you know, if I just showed you a chart with auto loan, subprime auto loan delinquency rates or credit card delinquencies, you would say, oh my God, like we're in recession. Like there's no way this can be right in an economy that's actually still expanding. There's a lot of reasons for that. I think you've had an affordability shock, you know, a simultaneous increase in cost of servicing the debt. Obviously, inflation weighs a lot more heavily. The tailwind from the post-COVID stimulus, you know, kind of faded.
So it was too much happening at once a little bit for the low end of the income distribution in consumer. Now, what does that mean for the future? I think it means that if for whatever reason we have an exogenous shock that, you know, that weighs on the broader economy, there's no question that the low end of the income distribution among consumers will be going into that shock in a position of weakness. And so that is that that sort of creates its own vulnerability for sure.
Sunny Oh
Sure. No, no. It definitely seems like a hot topic that especially among, you know, so we have a distressed team and they cover a lot of the concerns around the subprime lenders. They've been a favorite short among some hedge funds. You know, it does seem they're quite worried. And, you know, obviously, they're talking their own book. Some of these are distressed hedge funds. They wouldn't mind to see bonds for some of these companies trade down. But it does seem to reflect these broader macro fears.
Lotfi Karoui
Yeah. Yeah.
Sunny Oh
All right. You know, we've talked a lot about software, but there's also sort of the flip side of this, which is sort of the AI disruption and the issuance that is perhaps fueling that sort of these AI driven data center bond offerings. And, you know, there's a lot of questions around, are there too many of these things hitting the market?
You know, we've already heard anecdotally on the project finance side that the banks may have already been stuffed to the gills with this stuff. And so it seems like part of the logic for going to public credit markets is we need more channels, more liquidity to fund this immense amount of capital that's being forecasted for the next few years. You know, how do you see that congestion issue panning out? And do you even think it is an issue? You know, it's a point of debate. It's not something that's just being told.
Lotfi Karoui
I mean, actually, you started the discussion by asking me what we talked about, you know, in Europe. That was actually another topic of conversation.
Look, so the CapEx figures are spectacular, to say the least. I mean, if you believe consensus estimates, we're expecting a trillion and a half of CapEx among the hyperscalers. So I'm not even including the entire, you know, AI ecosystem. Just for the hyperscalers, it's one and a half trillion dollars for 26 and 27. That will very likely absorb over 90% of cash flows from operations. This is why you're seeing that shift from, you know, relying entirely on internal resources to fund that into relying on debt capital markets to do it. That explains that.
And that inflection point happened probably a couple of quarters ago where you started to see more debt issuance. Now, the concern that you hear is this sort of the late 90s all over again, right? Are we excessively relying on debt markets to finance CapEx? And are we overbuilding? Of course, time will tell. But I think there are, while you can always point to similarities, I think there are differences that are important to keep in mind with the late 1990s. One, today's tech sector, particularly the hyperscalers, you know, is way more profitable than telecom back in the late 90s.
There's pressure on free cash flows for sure because, you know, again, the needs are quite substantial. But if you look at the, if you took a snapshot of today's balance sheet in tech and compared that to telecom back in the 90s, it's night and day. Like there's way better quality today. You know, if I bring it a little bit closer to home and I look at, you know, sector level credit metrics and investment grade, tech is actually the least leveraged sector. So there's plenty of debt capacity in, you know, in the tech sector.
Now, that doesn't mean the equity market will not one day wake up and start asking questions about the CapEx and say, okay, wait a minute, you're spending all this money. Where's the return on equity? You're not immune from that. But I think from the perspective of a bond holder, I don't think this is the late, late 1990s, which is sort of a concern that you hear all the time. I think there's still quite, quite a lot of, you know, debt capacity.
And again, the re-leveraging impulse is real. It's happening. You know, tech is adding more debt on balance sheet, no doubt about it, but it's doing so from a very, very low starting level. And at the moment, you know, I'm not, I'm not that concerned. By the way, the market is paying attention too. Yes. It's not like this is taking anyone off guard.
I mean, look at IG tech versus the index. I mean, two years ago, the tech sector would trade at a ratio of the index of probably 0.6. Now it's over one. So you've, you've sort of, you know, you, you, investors did what they are supposed to do, which is demand a high risk premium in the face of that re-leveraging, you know, impulse. Now, can that become a credit quality problem? You know, a couple of quarters down the road, I think it's, the bar is a lot higher than most people think. It can happen obviously, but it's a high bar.
Sunny Oh
And I guess that assumption is also based on the idea that they can turn this off. You know, they can pull back on capex, right?.
Lotfi Karoui
Of course, of course, if you want to defend your rating and act in a way that is a lot friendlier to bondholders than shareholders, you can totally do that. Absolutely. That's a great point.
Sunny Oh
Great. I think I've taken a lot of your time, but I really appreciate this time, Lotfi, and welcome to 9fin. Thanks.
Lotfi Karoui
Thank you. That was fun. Thank you.