Implications of Lower Base Rates Not All Bad For Direct Lenders

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Fed Rate Cutting Cycle Implications For Direct Lending Returns

Key Points:

• The Federal Reserve has restarted a rate cutting cycle after an 8 month pause.
• For direct lending investors, lower SOFR means lower yields, but it also means potentially healthier borrowers, more M&A activity, and lower cost of liabilities.

Bottom Line:

Lower base rates may trim near-term returns, yet history and today’s SOFR curve point to attractive risk-adjusted outcomes ahead. We believe direct lending’s income, credit protections, and relative premium are poised to remain intact over the cycle.

Implications of Lower Base Rates Not All Bad For Direct Lenders

On September 17th, the Federal Reserve cut the Fed Funds rate by 25 basis points as widely expected, with the most recent Fed “dot plot” suggesting a further slow descent ahead for the Fed Funds rate from just over 4% to just over 3% by early 2028. In contrast, the 3M term SOFR forward curve¹ suggests a slightly faster pace of cuts, with SOFR bottoming at just below 3% by late 2026/early 2027 (as of Sept 17th).

For floating rate loans, this expected ~1% drop in SOFR base rates is an obvious headwind to the absolute yield income component of returns, and will likely lead to cuts in supplemental and some base dividends for BDC’s – especially those with low or negative net investment income (NII) dividend coverage, high non-accruals and/or high levels of non-cash paying PIK. Some BDC’s have already cut their dividends.

Net Investment Income includes Payment-In-Kind (PIK) income (see Exhibit 2) which is non-cash, and this too bears on a BDC’s ability to cover its cash dividend payment requirements.

That said, a 1% drop in base rates is not particularly dramatic as far as interest rate cycles go and presumably not outside the bounds of most BDC boards’ planning assumptions. In addition, there are other offsetting positives that come with a 1% drop in base rates that can help offset lower yields on portfolio assets including:

1. Lower cost of capital on floating rate liabilities as an offset to reduced interest revenue
2. Ability to alter fund level leverage, subject to deployment opportunities
3. Asset mix management (e.g. minimize lower yielding broadly syndicated loan holdings). Here, however, it’s important not to have too much style drift or to chase much higher risk assets

In addition, the market may help with:

1. Increased M&A activity as rates fall
2. Increased fees related to increased portfolio turnover
3. Potentially lower loss rates as borrower interest cost burden falls
4. Spread stabilization and possible widening depending on economic circumstance

How Has Direct Lending Performed in Prior Cycles?

There have been two major historical Fed interest rate cutting cycles since the Cliffwater Direct Lending Index started in 2004, with the third currently underway as can be seen in Exhibit 3. However, the previous two rate cutting cycles were accompanied by recessions (Global Financial Crisis and Covid recessions), and base rates in both cases fell to near zero. The current cycle, in contrast, does not appear to be on the same course, with base rates expected to bottom near 3% before rising once again. Whether a recession is forthcoming is of course uncertain. Most economists forecast a slowdown but not a recession, and the Atlanta Fed’s GDPNow indicator currently points to a relatively healthy ~3% GDP growth rate in 3Q25.

That said, the odds of a recession in the next 12 months may have risen following a string of weak labor market statistics and a related recent fall in consumer confidence. If there is a recession forthcoming, it would no doubt weigh on direct lending return performance. As can be seen in Exhibit 3, the Cliffwater Direct Lending Index (CDLI) experienced a peak 6% quarterly drawdown in 4Q08 during the GFC recession and an almost 5% drawdown in 1Q20 at the start of COVID. Here, however, it is important to bear two things in mind:

1. The peak CDLI quarterly drawdowns were modest relative to other asset classes like leveraged loans, high yield bonds, and stocks during these recessionary periods and;
2. The CDLI drawdowns during the GFC and COVID recessions were primarily associated with unrealized losses which either turn into realized losses or cancel out over time. If one excludes the unrealized loss component of the CDLI’s returns and just looks at the realized gains/losses and income components of the CDLI’s returns since 2004 (blue line in Exhibit 3), the only negative return quarter over the period was -0.34% in 4Q09 when enough unrealized losses in the previous quarters were converted to realized losses to offset the income component of return.

Long Term Risk Adjusted Return Prospects Remain Favorable

As can be seen in Exhibit 3, the most recent SOFR curve continues to point to “higher for longer” base rates in the future vs. most of the past 2 decades. Granted an average 3.3% SOFR rate over the next 10 years, Cliffwater LLC continues to show an attractive expected risk/return profile for direct lending (shown as “Private Debt” in Exhibit 4) on both an absolute basis and relative to most other asset classes (see Exhibit 4).

When a recession will arrive is hard to forecast, but one will come at some point. When it does, direct loan performance is expected to be resilient, particularly for managers with disciplined credit selection, experience through multiple cycles and deep workout capabilities. Should a typical recession case scenario transpire in the year ahead, Cliffwater analysis suggests three-year annualized returns could recover to 7.8% for the CDLI.²

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