The 5% default rate in private credit, compared to 3% in syndicated loans, is a function of its target market: smaller companies. Just as the Russell 2000 is more volatile than the Dow Jones, smaller businesses are inherently riskier. Applying leverage to a more volatile asset pool naturally results in more defaults.

Unlike in past cycles, the riskiest underwriting has largely occurred in leveraged loans and private credit, not high-yield bonds. This migration has left the public high-yield market with higher-quality issuers and shorter durations, making it more resilient than its reputation suggests.

Default rates are not uniform. High-yield bonds are low due to a 2020 "cleansing." Leveraged loans show elevated defaults due to higher rates. Private credit defaults are masked but may be as high as 6%, indicated by "bad PIK" amendments, suggesting hidden stress.

Historical analysis of distressed cycles in sectors like energy and retail shows that roughly one-third of the industry's debt defaulted over a two-year period. Applying this precedent to the software sector, which has approximately $300 billion in debt, suggests a potential default wave of around $100 billion if current pressures continue.

Counterintuitively, high-yield corporate bonds are expected to perform better than investment-grade credit. They do not face the same supply headwind from AI-related debt issuance, and their fundamentals are supported by credit team forecasts of declining default rates over the next 12 months.

Angelo Ruffino of Bain Capital forecasts that default rates in the software lending sector will significantly exceed the broader leveraged loan market average of 4-5%, potentially reaching high single-digit or even low double-digit percentages due to AI disruption and over-leverage.

Software's heavy presence in leveraged loan (<15%) and private credit (>20%) portfolios makes these markets more vulnerable to AI disruption than high-yield bonds (<5%). This concentration risk is already visible, with the distressed universe of leveraged loans growing 50% year-to-date, a stress not yet seen in the bond market.

Once considered safe due to low CapEx and recurring revenue models, the technology sector now shows significant credit stress. Investors allowed higher leverage on these companies, but the sharp rise in interest rates in 2022 exposed this vulnerability, placing tech alongside historically troubled sectors like media and retail.

Despite higher spreads in the loan market, high-yield bonds are currently seen as a more stable investment. Leveraged loans face risks from LME activity, higher defaults, and investor outflows as the Fed cuts rates (reducing their floating-rate appeal). Fixed-rate high-yield bonds are more insulated from these specific pressures.