Facing an increase in benchmark interest rates since early 2022, many borrowers have sought ways to manage rising funding costs. One method involves companies converting cash interest tranches to payment-in-kind (PIK)--that is, adding to the principal that's due to a lender in lieu of making cash interest payments.

PIK payments have reportedly increased among highly levered borrowers seeking to preserve cash flows. This is especially the case within private credit, where borrowers have more flexibility to negotiate such terms with lenders.

In recent quarters, loans making PIK payments have continued to expand their presence within the portfolios of business development companies (BDCs)--both in terms of their total amount and also as a share of the loans held by BDCs overall (at fair value).

S&P Global Ratings expects that, eventually, falling interest rates will ease the pressure on cash flows and lead to a gradual reduction in borrowers deferring on their interest, even as we expect PIK to continue as an optionality for the issuer.

Through the portfolios of BDCs and interval funds (nontraded closed-end funds that offer periodic redemptions for a set percentage of outstanding shares), we can get a glimpse of the slice of the loan market that they hold. We've used the public filings of these BDCs to estimate the share of their loan assets that are making PIK interest payments.

PIKs Have Climbed Over The Past Year

With more borrowers opting to make noncash interest payments, the amount of loans making PIK payments within BDCs' portfolios has risen to $39.1 billion in loans (at fair value) in the second quarter of 2024, up from just under $25 billion in the second quarter of 2023. Together, these loans represented about 11.7% of the total fair value of the loans held by BDCs in the second quarter, up slightly from 11.5% in the first quarter. (These estimates of the amount and share of loans making PIK payments are based on available disclosures from more than 165 BDCs, including both rated and unrated BDCs and interval funds. The estimates are more likely to understate, rather than overstate, the actual share of loans making PIK payments.)

Loan structures that have the option to PIK are still on the rise, and within the portfolios of BDCs, we've seen increases in PIK-paying instruments among both private-credit loans and broadly syndicated loans, or BSLs (see chart 1). (To be clear, the BSLs paying PIK in our estimate specifically reflect those held by BDCs, and they may not represent the BSL market more broadly.)

Chart 1

The impetus to preserve cash flow that leads to PIK payments can be a sign of stress for some borrowers, particularly if it indicates an inability to meet cash interest demands. But in recent years, some borrowers have also opted for financing that allows PIK payments up front, such as recurring revenue loan structures.

Just 10% of the loans (by fair value) currently making PIK payments are scheduled to mature through 2025, and more than two-thirds of these loans won't mature until at least 2028 (see chart 2). This suggests that most of the loans that are currently making PIK payments are of more recent vintages.

Chart 2

Among the 14 publicly rated BDCs, PIK income remains elevated as a share of gross investment income, and many saw the PIK share of gross investment income expand between the first and second quarters of this year (see chart 3). On average, PIK income accounted for about 9.5% of interest income in the second quarter, versus about 8.5% both at year-end 2023 and a year ago. Despite this modest uptick, most of the PIK interest and dividends are associated with performing investments that were originated with a PIK feature and where only a minority of PIK interest is due to amendments, in our view. We view amended PIK investments as an indicator of stressed borrowers.

We've seen that BDCs with scale have the ability to identify and amend their potentially underperforming investments by temporarily converting cash interest to PIK. Over the next 12 months, we expect that BDCs' overall PIK income will rise--they're predominantly fixed rate, and an expected decrease in base rates will lead to lower net investment income (denominator effect). We also expect that the rise in PIK income will reflect select borrowers continuing to face liquidity pressures; still, our expectation is that overall PIK levels will be manageable for rated BDCs.

Chart 3

Private Credit Grows As A Share Of BDC Assets

The increase in PIK loans in the second quarter accompanied the continued growth of BDC assets. The fair value of the assets held by BDCs and interval funds rose by 8% quarter on quarter, to $402 billion. Loans accounted for the majority of these assets (84%). This reflects the mandate of BDCs, which were created in the U.S. by an act of Congress in 1980 to provide capital to small and midsize borrowers.

Within the loan portfolios, BDCs and interval funds hold both BSLs and private-credit loans. Private credit accounts for the majority of assets (58.3%), and this share rose by just over a percentage point from the first quarter (see chart 4). Meanwhile, the amount of BSL assets continued to climb in the second quarter, with the amount of BSL holdings up nearly 8% over the prior quarter (even as BSLs remained largely steady as a share of total assets).

BSL holdings tend to be higher within the portfolios of perpetual, nontraded BDCs and interval funds; both may aim to hold more liquid assets than publicly traded BDCs, which are set up as closed-end funds.

Nontraded BDCs and interval funds must manage liquidity to meet periodic investor redemptions. Even though redemptions are capped at 5% of net asset value on a quarterly basis, nontraded BDCs and interval funds hold relatively more BSLs than publicly traded BDCs do. Because BSLs trade in secondary markets, these holdings can constitute some of the more liquid assets that a BDC can sell, should the need arise. Private credit, by contrast, is largely illiquid and without a secondary market, and fund managers generally plan to hold these assets to maturity.

We see a consistently higher share of BSL assets within the portfolios of nontraded BDCs and interval funds than within the portfolios of publicly traded BDCs (see chart 5). While nontraded BDCs and interval funds currently hold roughly 33% of their loan assets in BSLs, that figure for publicly traded BDC portfolios is closer to 25%.

With fewer liquidity demands, publicly traded BDCs can potentially afford to hold a greater share of more illiquid private-credit assets.

Nontraded BDCs (which include both private and perpetual nontraded) now account for almost half of total BDC assets, while publicly traded BDCs account for 38% and interval funds account for nearly 13%. Nontraded BDCs have seen 46% growth over the past year, more pronounced than the 4% growth at publicly traded BDCs (see chart 6).

Chart 4

Chart 5

Chart 6

Opportunities For Refinancing

Issuance has surged in the rated leveraged finance credit markets with ample funding available, giving borrowers an opportunity to push out near-term maturities. This trend appears to be happening in private credit, as well.

BSL issuance volume has nearly doubled year over year through November in the U.S., with much of the proceeds going to repricing and refinancing (according to PitchBook | LCD). Since the beginning of 2024, borrowers have reduced the annual maturities of U.S. speculative-grade debt for 2025 through 2027.

Similarly, we've seen a decline in the amount of private credit maturing in 2025 and 2026 over the past year. Between the second quarter of 2023 and the same period in 2024, the amount of private credit held by BDCs set to mature in 2025 dropped 33% to $13.1 billion, and the amount set to mature in 2026 fell 11% to $29.9 billion (see chart 7).

As funds are growing, and with dry powder to deploy, the amounts of private-credit loans maturing in 2027 and 2028 have both increased--8% and 32%, respectively. These private-credit maturities peak in 2028, when $61.7 billion is set to mature, and that's also the year when speculative-grade maturities are set to peak.

Chart 7

The Fall In Funding Costs Will Come With A Lag

The decline in benchmark interest rates in the second half of 2024 will contribute to lower funding costs, but we expect there to be a lag. Normally, this is because floating-rate debt adjusts quarterly (or less often).

There was some level of repricing in the private-credit market in anticipation of improved financial conditions with the rate cuts, low unemployment, and low inflation. But the yields on loans held by BDCs didn't move significantly lower. Average yields on both private-credit loans and BSLs held nearly steady, at 10.8% and 9.9%, respectively. The funding premium for private credit narrowed slightly, by two basis points (to 87 basis points) from the prior quarter (see chart 8).

Funding costs for these borrowers will likely ease in coming quarters, with the rate cuts in the second half of this year, continued robust issuance of leveraged loans and collateralized loan obligations, and the recent tightening of spreads.

Chart 8

With ample funding available through both the private-credit and broadly syndicated markets, these markets are finding a balance. Smaller borrowers, or those looking for the flexibility of PIK or delayed-draw options, may be finding that private credit is suited to their need for certainty and execution. Meanwhile, larger borrowers benefit from the scale and pricing of BSL lending.

Within BDCs' portfolios, we see this dynamic increasingly playing out through the growing size of individual BSL borrowers. Although the average size of a private-credit borrower has also grown (6% quarter on quarter, to $51.8 million), the growth in the average size of a BSL borrower has been more pronounced (9% quarter on quarter, to $65.9 million). These amounts reflect only the debt held by BDCs, and these averages don't include the debt of a borrower that is held by other institutions, such as a credit fund or in a collateralized loan obligation.

Chart 9

Borrowers this year have encountered accommodative financing conditions across both broadly syndicated and private-credit markets. With both options for funding available, the markets appear to be taking on specialized roles: BSLs can provide tighter pricing for a deal that's large enough to benefit from the scale, while private credit is better suited to provide execution speed, certainty, and flexibility, particularly for smaller deals that would be inefficient for broad syndication.

Related Research

• Default, Transition, and Recovery: The U.S. Leveraged Loan Default Rate Is Set To Fall To 1% By September 2025, Nov. 27, 2024
• Economic Outlook U.S. Q1 2025: Steady Growth, Significant Policy Uncertainty, Nov. 26, 2024
• Credit Trends: Global Refinancing: Reductions In Near-Term Maturities Continue Ahead Of Further Rate Cuts, Oct. 23, 2024