For three years, defaults have been "soft" (e.g., liability management exercises, PIK interest), masking underlying issues. The market is now entering a second phase of "hard defaults" where losses will be directly felt through restructurings and bankruptcies, changing the nature of the cycle.

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.

The market is not heading for a 2008-style crisis with massive default spikes. Instead, it will experience a sustained period of 3-5% default rates for several years. This cumulative "slow burn" will be painful as many over-leveraged companies, financed in a zero-interest-rate environment, face restructuring.

The large volume of CRE debt maturing in upcoming years is less of a hard "wall" and more of a "movable partition." Lenders and borrowers have been proactively managing this through extensions and workouts. This process progressively filters out the worst assets over time, reducing the risk of a single, catastrophic wave of defaults.

Unlike the 2022 energy shock post-Ukraine invasion, the current market is not emerging from a decade of zero interest rates. U.S. real rates are already positive, and EM economies have built up buffers after being stress-tested, making a repeat of 2022's widespread defaults less likely.

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.

Unlike past recessions where defaults spike and then recede, the current high-rate environment will keep financially weak 'zombie' companies struggling for longer. This leads to a sustained, elevated default rate rather than a sharp, temporary peak, as these firms lack the cash flow to grow or refinance.

After a decade of abnormally low defaults, the credit market is experiencing a return to normal levels, driven by rate hikes and inflation. PGIM sees this not as an alarming trend but as an expected normalization for single-B assets, especially as the broader economy remains resilient.

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.