While AI is currently propelling the stock market to new highs, it presents a significant and growing threat to the opaque private credit sector. Experts are forecasting a substantial increase in private credit defaults, exacerbated by AI’s disruptive impact on the software industry, which serves as key collateral. This precarious situation could expose retail investors and major banks to considerable financial fallout, even as public markets demonstrate continued strength.
Defaults within the highly opaque private credit sector are projected to escalate further after reaching unprecedented levels in April. Financial experts are now sounding alarms, suggesting that individual retail investors might not be immune to the impending repercussions. The confluence of booming artificial intelligence models, persistent inflation, and elevated interest rates is significantly straining the corporate loans that serve as collateral for private credit funds. This pressure has already prompted some investors to attempt withdrawals, despite the sector's inherent illiquidity.
Credit analysts are intensifying their warnings, predicting that risks will heighten throughout the remainder of the year. This is largely due to mounting pressure on the software sector, which underpins a substantial portion of the securitized loans favored by private credit. Software businesses constitute approximately 19% of the assets backing private credit collateralized loan obligations (CLOs), also known as middle-market CLOs, according to S&P data.
Matthew Mish, a strategist at UBS, noted on Thursday, "Our updated perspective points to a meaningful increase in private credit defaults, rising from roughly 4.4% to 9–10%, driven in part by the implications of the AI cycle." He further elaborated, "Risk is expected to evolve over the next year, intensifying toward year-end and into early/mid-2027 as software businesses experience slowing growth, waning pricing power, margin compression, and contract cancellations."
Salesforce's recent stock performance, which declined despite robust profit and revenue figures, illustrates the challenges confronting the software industry. Several prominent Wall Street firms have expressed concerns about the company's long-term growth prospects in the face of AI advancements. Bank of America analyst Tal Llani remarked on Thursday, "There is increasing risk that AI labs like OpenAI and Anthropic expand downstream into enterprise applications such as Salesforce Inc."
Ratings agency Fitch reported a record-high 6% private credit annual default rate in April, with ten distinct default events occurring that month. Over the 12-month period ending in April, Fitch recorded 99 diverse types of defaults, including deferred interest payments, maturity extensions under duress, payments-in-kind instead of cash, as well as more conventional bankruptcies, liquidations, and debt-equity swaps.
The situation in private credit has, so far, unfolded more like a slow-motion catastrophe rather than an abrupt collapse. Funds have utilized "amend-and-extend" strategies and imposed withdrawal limits, hoping that loan collateral values will recover as macroeconomic conditions improve. However, some voices are cautioning about an approaching cliff edge where further mitigation efforts may become impossible.
Jeffrey Gundlach, CEO of DoubleLine Capital, posted on social media last month, "Beware the ides of June." He elaborated to CNBC at the end of April, "You're going to get humongous withdrawal requests from these interval funds in June, and I think that's going to be a catalyst for more angst."
Retail investors may not be insulated from the repercussions, particularly if the fallout impacts banks, which had lent approximately $300 billion to private credit by last year, according to Moody's. Laks Ganapathi, founder of Unicus, also highlighted the involvement of numerous blue-chip financial institutions. "You have KKR with Capital Group, Goldman Sachs Asset Management, Blue Owl, Apollo, BlackRock, Blackstone with Wellington and Vanguard – they are all collaborating and completely infiltrating, for lack of a better word, into retail [retirement] accounts," she stated on Thursday.
Concurrently, some major state pension funds hold multiple private credit investments and are maintaining their positions despite the identified risks. Pension systems in Kentucky, Arizona, California, Virginia, and other states possess significant exposure to private credit, as documented by the Boston College Center for Retirement Research and reported by Reuters.
UBS's Matthew Mish also pointed out that potential spillover effects from private credit markets into public credit markets are "underappreciated." He wrote on Thursday, "Investor bases overlap significantly, particularly among insurance companies, foreign investors, and to a lesser extent retail participants."
However, DoubleLine's Gundlach offered a contrasting perspective on these linkages, citing the robust performance of public securities markets in recent months. He told Bloomberg earlier this month, "[People] say, because they can't get out of private credit, they're going to sell public credit" – referring to stocks, high-yield bonds, bank loans, and corporate bonds. "The only problem I have with that is it's not happening at all. The stock market is not in trouble, it's at new highs … You'd think if there was something to that concept, we'd see more evidence of it."
