Debt black hole: Private credit markets showing signs of stress

According to Wall Street Journal analysts, the private credit market is under increasing stress, with default rates spiking and internal reviews of loan health pointing to “tougher times.”

When we think about this massive Debt Black Hole, the national debt immediately comes to mind. However, there’s more to it than government debt. Consumers are buried under trillions in debt, and corporations are levered up to the hilt. As this Debt Black Hole expands, its “gravitational pull” is having an increasingly significant impact on the broader economy.

Private loans total around $1.4 trillion, representing roughly 10 percent of debt held by non-financial corporations in the U.S., according to Federal Reserve data.

Non-bank lenders make up the private credit market. These entities raise capital through institutional investors, pension funds, endowments, wealthy individuals, and others. These funds then loan money directly to companies or individual projects. This private loan market offers companies and entrepreneurs a source of non-bank financing that is often more flexible and lax in underwriting.

The private credit market grew in both size and importance after the 2008 financial crisis. With banks facing stricter capital and lending regulations, private financing funds stepped in to fill the financing gap.

Meanwhile, investors poured money into the private credit funds hoping for bigger returns than they could earn buying traditional bonds.

While private loans still make up a relatively small share of total corporate debt, a collapse in the market could easily spread into the broader credit markets and lead to a financial crisis.

The dynamics are not unlike the subprime mortgage market in 2005, 2006, and 2007. At the height of the housing bubble, subprime only accounted for about 13 to 15 percent of all mortgages. Nevertheless, the collapse of subprime took the entire housing market down with it and pulled the economy into the Great Recession.

Stress in private credit

Up until recently, private-credit funds were one of the “hottest flavors” on Wall Street thanks to their big returns. However, big returns generally involve big risk. Last year, the risk caught up with the industry and things turned sour.

There were several high-profile defaults and allegations of fraud, along with a large number of loans made to software companies at risk of disruption due to AI. In response, investors began asking for their money back.

Facing record withdrawal requests, some funds restricted redemptions and limited withdrawals.

Fund managers claim the problems were overhyped and insist that everything is fine. However, now there is a new source of stress. A review of quarterly reports issued by the biggest players in the private credit market by the WSJ shows “loan health and investor returns are worsening.”

Private credit funds overseen by Ares Management, Blackstone, Blue Owl Capital and Golub Capital reported loan defaults hitting the highest level since 2021, a year into economic chaos caused by the pandemic.

For instance, the default rate at Blue Owl’s fund hit 2.8 percent in Q2, the highest level in at least five years. According to the WSJ, non-performing loans at the other funds also hit five-year highs, exceeding levels seen during the spike when the Federal Reserve was tightening monetary policy and raising interest rates in 2023.

According to Fitch Ratings, the U.S. private credit default rate stood at 6 percent at the end of May.

According to the Wall Street Journal, defaults currently appear to be concentrated in the healthcare sector and businesses most heavily impacted by rising oil prices. For instance, Loparex, a firm that makes plastic film, recently defaulted.

Fitch reported 14 defaults in May alone.

“Issuers in the healthcare providers, industrial and manufacturing, and business services general sectors each accounted for three events, while the food and beverage and tobacco, banking and finance, transportation and distribution, environmental services, and telecommunications sectors each accounted for one event.”

Analysts worry that the default bug could begin to spread into the software sector. In many private credit funds, 20 percent or more of the outstanding debt is owed by software companies.

Private credit funds also report an increase in the number of companies on their “watchlist” showing signs of trouble.

As the WSJ reports, private credit investment firms can’t afford any more write-downs after a rough 2025.

“The performance of their funds is already suffering, and their stock prices have only just started to recover from sharp selloffs that started last year.”

While default rates are rising, they remain below levels seen during high-stress periods such as the pandemic and the oil price crash in 2015. The WSJ noted, “Losses could abate if interest rates decline and economic activity remains robust without pushing inflation higher.”  

That’s a lot of ifs.

While the CPI has cooled, other data points point to increasing inflation. And even with the CPI moderating, it remains well above the 2 percent target. That means the Fed needs to keep interest rates higher for longer. There isn’t a lot of hope for rate relief as long as the economy keeps stumbling along and CPI remains stubbornly above the mythical target.

Fund managers insist everything is fine, and Wall Street seems to be buying their narrative. Private credit investment has rebounded modestly over the last few months. But additional defaults could tip the boat. The Wall Street Journal noted that if returns stay stuck or drop, more investors may walk away.

“Fewer investors mean it would be harder for fund managers to raise money, shrinking the supply of capital to refinance existing corporate loans when they come due.”

So, despite assurances from fund managers, warning signs are flashing in the private credit market. It faces a double whammy of contracting liquidity and deteriorating loan portfolios.

That’s a recipe for a private credit meltdown that could spread into the broader financial markets.

Don’t forget that everything was fine in subprime in 2006 and 2007 – until it wasn’t.