A 'significant' private credit shakeout on par with Covid losses is coming, predicts Morgan Stanley

Morgan Stanley warns direct lending default rates could rise to 8%, approaching Covid-peak levels, driven by AI disruption of software borrowers. Direct lenders' estimated software exposure is 26% (BDC holdings) and 19% (private credit CLOs); software loans show the highest leverage and weakest coverage, with 11% maturing by YE27 and 20% in 2028. Private market redemptions have pressured managers—Blue Owl sold $1.4B of loan assets in February and is down 41% YTD, while Blackstone is down nearly 31% YTD. Strategist Joyce Jiang views risks as significant for private credit but not systemic, citing healthier corporate balance sheets and lower leverage in funds/BDCs versus past crises.

Analysis

This is primarily a credit-liquidity event concentrated in middle-market software exposures rather than an immediate banking solvency shock. The key transmission channels are (1) mark-to-market markdowns and redemptions that force private managers to sell loans into a thin secondary market, and (2) a front‑loaded maturity wall for software loans that creates refinancing cliffs in 12–36 months for credits with high leverage and weak coverage. Both channels amplify realized defaults even if underlying corporate cashflows degrade only modestly.

Second-order winners will be players with large balance-sheet capacity and low mark-to-market exposure: well-capitalized banks that can originate and hold first‑lien paper, and asset managers offering floating‑rate credit with liquidity gates to mute redemption spirals. Losers extend beyond visible BDCs and listed private credit managers to loan servicers, CLO equity holders, and market-makers in leveraged loans—places where concentrated selling can cascade into wider spread dislocation.

Tail risks to watch: a self-reinforcing cycle of redemptions → fire sales → rising realized losses could push leveraged loan spreads materially wider in 3–12 months, creating stress in synthetic credit markets and corporate rollover markets. Reversal catalysts include a rapid re-pricing of private credit spreads, managers imposing gates/side‑pockets that stabilize NAVs, or evidence that AI adoption boosts revenue for a large share of software firms, improving coverage ratios within 6–18 months.

Key Decisions for Investors

• Short OWL via a 6–9 month put spread (buy 6–9m puts, sell further OTM puts) sized 1–2% NAV: asymmetric payoff if markdown cycle continues; limit max premium paid to 1% NAV. Rationale: highest immediate beta to private credit redemptions; risk is short-term mean reversion or event-driven recapitalization, cap loss at premium paid.
• Short OBDC equity (or buy 3–6m put spread) size 0.5–1% NAV as a tactical hedge against BDC-specific NAV markdowns over the next 3–12 months. Pair with a small long in senior-secured bank loans (floating-rate) to capture carry if spreads overshoot; target 20–40% downside on the short leg vs capped loss at option premium.
• Long Morgan Stanley (MS) 3–9 month call spread (modest size, 0.5–1% NAV) to play trading/advisory fee tailwinds and market‑making revenue if volatility and restructuring pick up. Reward: outsized trading income in a volatile credit cycle; risk: broader market drawdown that compresses fees.
• Buy 3–12 month protection on leveraged‑loan/IG‑HY credit risk (CDX.HY or HYG put structures) sized to cover expected portfolio exposure—use as portfolio insurance rather than directional bet. Cost is drag if no dislocation; payoff protects against a stressed default wave that would hit private-credit‑exposed holdings hardest.