Credit markets are at a crossroads. Credit fundamentals have been gradually deteriorating under the strain of interest rates, which are still elevated by historical standards. Yet with expectations growing that a cutting cycle could begin as soon as this month, some relief is likely on the way. So far, the backdrop has been benign: Defaults remain low, spreads are contained, and fundamentals are broadly supportive of current valuations. The key question is whether we are past the danger zone as monetary policy begins to ease, or whether hidden risks are quietly building that could push defaults higher. Beneath the surface, a divergence is becoming clear.
Public credit fundamentals have undergone many structural changes over recent years. Investment grade (IG) issuers entered this cycle with unusually high cash and liquidity balances. As a result, despite higher policy rates, net interest expense initially declined as IG companies benefited from higher yields earned on large cash balances and from termed-out fixed-rate debt. Interest coverage remains strong, but that cushioning effect will now fade. As the Fed cuts rates, these firms will enjoy less interest income on their cash while also refinancing existing low-cost debt into marginally higher all-in yields. On balance, credit fundamentals will continue to modestly deteriorate, but we do not expect any macro risks to emanate from this part of the market.
Unlike all other parts of the credit markets, high yield (HY) has undergone a structural upgrade relative to previous cycles, with higher-quality issuers making up more of the market. Driving this shift are the rise of private debt, which has shifted the weakest borrowers out of HY and into less regulated private markets, and fallen angels from the investment-grade universe, which have lifted overall quality. As a result, HY now has the highest credit quality in its history, with the majority of constituents now at the BB rating level, while the riskiest segment (CCC), which historically drives defaults, has shrunk by roughly 30%-40% over the past 15 years. Here, too, we see limited scope for a large default spike.
Leveraged loans have seen the opposite dynamic to HY, with the average rating grinding down from BB to single-B. Although loans have weakened somewhat due to looser covenants, coverage ratios have improved from their recent trough, and further rate cuts should continue to ease the burden given the floating-rate nature of the asset class. Overall, both the HY and leveraged loan markets remain relatively strong, and defaults are expected to stay contained absent any exogenous events. Confirming this overall market outlook, our network of analysts see only idiosyncratic situations (mainly in the leveraged loan market) that could result in defaults.
The private market tells a different story. Over the last decade, enormous amounts of capital have flowed into private credit, which sponsors have struggled to deploy. This has led to a buildup of more than $400 billion in dry powder as of August 2025 (according to Preqin). The excess demand relative to the opportunity set available has led to underpricing of risk and heavy use of payment-in-kind (PIK)1 features. The greatest stress is concentrated at the upper end of the market, where platforms have exhausted institutional demand and are now looking to tap retail channels to sustain growth. The 2021–2022 vintages are the most problematic; struck in an era of inflated valuations, low base rates, and aggressive leverage, many of these companies failed to deliver the adjustments assumed at underwriting. With maturity walls building between 2025 and 2027, managers will face growing pressure from limited partners and stakeholders to resolve positions they can no longer defer. As a result, defaults are expected to rise in this cohort in 2026 and beyond, albeit from low levels.
In principle, monetary easing should offset this stress, but will it be too little too late? While the worst of the pressure may be behind us and monetary easing could provide some relief, rate cuts alone will not resolve the deeper structural issues confronting stressed private credit positions, as these companies face outsized obligations and diminished recovery potential. It is important to note, however, that with sufficient dry powder in the system, the asset class has the potential to absorb these stresses without broader spillover. Committed undeployed capital may step in, leading to losses for the prior lenders, yet without broader macro implications, such as a spike in layoffs.
From a macro perspective, it’s the labor market that investors are nervous about. Job growth has ground to stall speed. We have a labor market that is seeing virtually no hiring, firing, or quitting – an unusual and precarious equilibrium. The public credit markets are not expected to see a significant rise in defaults and are therefore fairly benign with regard to their labor market implications. However, private credit stress could finally be resolved through higher defaults in 2026. Many of the portfolio companies in question are mid-sized firms with substantial employee bases, and we therefore remain watchful for any signs that firing decisions are taking hold. While this is not our base-case expectation, it represents one of the potential channels through which private credit excesses could spill into the broader economy. Watch this space.
