The high-profile collapses of First Brands Group (a global auto-parts supplier) and Tricolor Holdings (a subprime auto lender) have stirred some alarm amongst investors. The central question investors are asking is: are these isolated failures, or early warnings of deeper credit stress?1
I think the answer lies somewhere in the middle.
First Brands’ bankruptcy is a striking story. The company, once an industrial roll-up boasting 26,000 employees and a portfolio spanning 25 well-known automotive brands, borrowed over $10 billion from a mix of Wall Street lenders and private funds. But as new directors and forensic accountants now sift through its books, they’ve uncovered what appears to be $2 billion in unaccounted-for funds and billions more in off–balance sheet borrowing. 2
From my vantage, it appears that exposure to First Brands’ bad loans is spread across dozens of banks and collateralized loan obligation (CLO) funds, which is actually a good thing. It means no one institution’s holdings are likely large enough to trigger contagion. Even still, it’s a sharp reminder of the lack of transparency that has crept into parts of the private debt market, now approaching $2 trillion in size. It is relatively common to see these types of credit quality issues creep up near the end of an easy money environment. Increased risk aversion for debt investors who have been searching for yield would be appropriate in response to the First Brands’ bankruptcy.
Then there’s Tricolor Holdings, a Texas-based subprime auto lender that targeted borrowers without credit histories or documentation. It filed for liquidation last month, listing more than $1 billion in liabilities. The business model, based on “buy here, pay here” auto sales financed through asset-backed securities, crumbled under rising delinquencies and tighter funding conditions. Now, some tranches of Tricolor’s securitized debt that once traded above par are only worth pennies on the dollar.
Taken together, these bankruptcies show how weaker players at the fringes of the credit spectrum are struggling. Years of easy liquidity and investor demand for yield have encouraged aggressive underwriting. As the economy normalizes and interest rates settle above the near-zero era, some of those bets are now being tested.
The private credit market, in particular, is where I’m increasingly turning my focus. Defaults in business development companies (BDCs) and other private-lending vehicles have been creeping higher. Roughly 11% of loans in these portfolios now pay interest “in kind”, that is, with IOUs instead of cash—signaling stress among smaller borrowers. Fitch’s measure of private credit defaults hit 9.5% this summer before easing slightly.
This is a market and a trend worth monitoring very closely. As I write, however, I think it’s important to qualify that “higher defaults” does not mean “credit crisis.” Public credit markets, the most transparent barometer of corporate financial health, aren’t showing much strain. High-yield bond defaults remain near 1%, well below their long-term average of around 4%. And investment-grade and high-yield spreads, as seen in the chart below, remain historically tight. Investors aren’t demanding higher risk premiums, which suggests the market is still confident that these issues are more local than systemic.
The takeaway for investors, in my view, is to acknowledge that credit markets are running hot. The additional yield investors receive for holding corporate debt versus Treasurys has fallen to near 25-year lows, prompting companies to issue debt at record levels. This strength underscores confidence in the market, but it could also signal investor complacency. It’s important to constantly try to differentiate between the two.
Bottom Line for Investors
If I could sum this story up in a single sentence, it would be this: Remember that easy money often sows the seeds of future problems.
Or put in an even simpler way: bad loans are often made in good times.
The failures of First Brands and Tricolor are cautionary tales, and I think they warrant greater investor attention. They remind us that in the far reaches of the private and subprime credit universe, excesses built up during the era of cheap money are still unwinding. Investors should watch these developments closely, but also be careful not to overreact. Evidence from broader credit markets, like tight spreads, low defaults, and contained fallout, does not point to systemic stress, at least not yet.
1 Wall Street. https://advisor.zacksim.com/e/376582/es-306d7869-mod-article-inline/5tql5g/1355093773/h/YN-hUysQ1y4uie04NzdszYAQt7KthqrMofBorT0yCqY
2 Wall Street. https://advisor.zacksim.com/e/376582/mod-Searchresults-pos-4-page-1/5tql5k/1355093773/h/YN-hUysQ1y4uie04NzdszYAQt7KthqrMofBorT0yCqY
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