The sectors with the most distress are tech, healthcare, and services, specifically among companies taken private via leveraged buyouts. Many of these deals were predicated on aggressive synergies and growth that failed to materialize, leaving them far more levered than originally planned and vulnerable to downgrades.
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.
Beyond direct competition, the private credit market serves a crucial function for public markets by absorbing lower-quality companies that can no longer refinance publicly. This migration of weaker credits helps cleanse the public high-yield and loan markets, removing potential defaults and improving overall portfolio quality.
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.
Superior investment opportunities often lie in sectors the market has written off, such as media, telecom, or previously, aerospace. These out-of-favor industries contain mispriced assets and offer better value for discerning investors compared to chasing yield in crowded, popular sectors where everyone already sees the upside.
A critical but overlooked risk for the U.S. credit market is rising interest rates in Japan. Japanese banks are major buyers of AAA-rated Collateralized Loan Obligations (CLOs). If domestic yields become more attractive, they may pull back, removing a significant source of demand that underpins the entire leveraged loan ecosystem.
A key risk for highly leveraged, sponsor-backed tech companies is not just debt, but existential competition from investment-grade giants. Large players like Microsoft or Google can easily replicate a smaller firm's niche product as a simple feature within their ecosystem, rendering the smaller company's entire business model obsolete.