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.

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.

Unlike syndicated loans where non-payment is a clear default, private credit has a "third state" where lenders accept PIK interest on underperforming loans. When this "bad PIK" is correctly categorized as a default, the sector's true default rate is significantly higher, around 5% versus 3% for syndicated loans.

Problem loans from the 2021-22 era will take years to resolve due to private credit's tendency to "kick the can." This will lead to a prolonged period of underwhelming mid-single-digit returns, even in a strong economy, rather than a dramatic bust.

Official non-accrual rates understate private credit distress. A truer default rate emerges when including covenant defaults and 'bad' Payment-in-Kind interest (PIK) from forced renegotiations. These hidden metrics suggest distress levels are comparable to, if not higher than, public markets.

This credit cycle could harm CLOs more than the 2008 crisis. The danger isn't a massive spike in defaults, but rather a prolonged period of moderate defaults combined with historically low recovery rates on those loans. This combination erodes value more effectively than a short, sharp shock.

A sign of eroding discipline, private credit underwriters are beginning to offer covenant-lite deals, once unthinkable in a market known for strong investor protections. This shift indicates that intense competition for deals is forcing lenders to lower underwriting standards, mirroring a late-cycle trend previously seen in public markets.

Rising default rates in European high-yield are not translating to proportionally higher losses. This is because modern capital structures are dominated by secured debt, leading to exceptionally high recovery rates (70% vs. a historical 40% average), which cushions the overall impact on investors.

The current rise in private credit stress isn't a sign of a broken market, but a predictable outcome. The massive volume of loans issued 3-5 years ago is now reaching the average time-to-default period, leading to an increase in troubled assets as a simple function of time and volume.