How will private credit and equity stocks react to Fed rate hikes?

Top companies in the private credit industry have pulled back over the past few days as investors reassessed their outlook on the Federal Reserve. Most have fallen into correction territory, dropping more than 10% from their recent highs. This article examines how the Fed's next move could affect these stocks.

Private credit stocks have pulled back this month

The biggest companies in the private credit industry are struggling, with their recent attempts to rebound facing substantial resistance. Blue Owl Capital OWL ended last week at $10.56 and has dropped by 56% from its highest level in January last year. This retreat has seen its market capitalization fall from $40 billion to $16.4 billion. 

KKR, the private equity pioneer that has also become a big name in the private credit sector, ended at $101, down by 13% from its highest level in August. Other companies like Apollo Global Management, Blackstone, and Ares have also dropped. 

Notably, the VanEck BDC Income ETF (BIZD) dropped to $13, down by over 4% from its highest point in August this year. This fund tracks the biggest business development companies in the US, including Ares Capital, Main Street Capital, Hercules Capital, Golub Capital, and Sixth Street Specialty Lending. 

Federal Reserve expected to hike interest rates

The main reason why these private credit stocks have retreated is that investors now expect that the Federal Reserve will hike interest rates in the upcoming meeting. Odds of this hike happening rose to over 80% on Polymarket and Kalshi. The same is happening on CME, where the FedWatch tool has jumped to 85%.

These odds jumped after the US released the recent macro numbers. For example, the report showed that the economy created 162k jobs last month, while the unemployment rate remained unchanged at 4.1%. 

Another data showed that inflation remained at an elevated level last month. The headline consumer inflation remained at 3.4%, while the core figure rose slightly on a month-on-month basis. 

Fed hikes and rising energy prices may hit private credit companies

In theory, the Fed rate hikes should be bullish for companies in the private credit industry. That’s because these companies offer their loans on a floating rate, which is based on the Secured Overnight Financing Rate (SOFR). 

In this, the interest rate they charge is usually calculated as SOFR plus a spread. As such, as interest rates rise, the profits they make are usually higher.

The challenge, however, is that higher interest rates, especially for a long time, normally affects the portfolio companies. Also, this is happening at a time when crude oil prices are in a strong upward trend. Gasoline jumped to $4.31, while diesel has jumped to a record high of over $6.1. 

Therefore, there is a risk that the higher rates and oil prices will lead to higher default rates in the coming months. This is happening at a time when many investors are redeeming their capital from private credit funds, including those run by companies like Blue Owl, Apollo, and Morgan Stanley.