Private credit default rates will climb, Morgan Stanley warns

Whenever the phrase “Covid peak levels” gets thrown around, let’s just say it’s usually not totally good news.

Holds true: Morgan Stanley analysts said default rates in private credit could climb to their highest level since the pandemic, spurred primarily by AI disruptions in the software industry, according to a note on Monday.

“In our view, AI disruption will be a meaningful catalyst to drive defaults higher in direct lending,” Morgan Stanley strategist Joyce Jiang said in a note, per CNBC. “Overall, we expect the direct lending default rates to reach 8%, approaching Covid peak levels.”

The private credit market has been on a rocky path lately, with investors pulling money from private credit funds, fearing AI disruption in the software market.

“Asset-light businesses where value is driven by intangibles such as software, IP, brands, and human capital face higher disruption risk as ‘good enough’ AI-enabled substitutes emerge,” Fitch Ratings said in a March 10 report on AI-related risks. “These sectors could see intensified competition and pressure on pricing and margins as AI lowers barriers to entry and reduces development costs.”

“Morgan Stanley estimates software exposure among direct lenders at 26%, based on the holdings of business development companies and 19% based on private credit collateralized loan obligations,” CNBC reported.

“Despite moderating defaults and benign ratings trend, credit fundamentals of software loans are challenged with the highest leverage and the lowest coverage ratios across major sectors,” Jiang wrote, per the outlet. “Moreover, the maturity wall of software loans is more front-loaded, with 11% set to mature by [year-end 2027] and another 20% in 2028.”

Other strategists see even greater hiccups ahead for private credit. In February, UBS Group AG strategists said that default rates could climb as high as 15% in the event of “rapid, severe AI disruption,” per Bloomberg.

Morgan Stanley strategists clarified that “while the broader risks in private credit are significant, they are not systemic, and pose limited danger of spillover to the wider market,” Bloomberg reported on March 16.