Trickling toward S&P Global Ratings' forecast for near-term easing to 3.5% by December 2025, the U.S. speculative-grade corporate default rate declined to 4.6% in March. But the rate still has a ways to go from 5.1% at the end of 2024, as ongoing uncertainty around tariffs and immigration policy keeps both direct lending and BSL markets on edge.

Before market sentiment soured, elevated default rates already reflected that many troubled borrowers were preemptively restructuring their debt outside of bankruptcy. Last year, 2% of firms in our CE universe opted to pay interest in kind (PIK), and over 90% of those cases triggered SD downgrades. The form of SD varies: for struggling middle-market borrowers it's often about negotiating interest payment relief, while for BSL issuers it typically involves distressed debt exchanges.

Unlike during the short-lived shock of the pandemic, today's investors are bracing for a more prolonged, broad-based slowdown-–one that could test sponsors' willingness to continue supporting portfolio companies.

The trade disruption comes when many speculative-grade firms in the U.S. and Canada are still showing solid performance. In fourth-quarter 2024, median trailing-12-month EBITDA ticked up 0.8% quarter over quarter but results were uneven. Forest products/building material/packaging companies, for example, continue to struggle with margin pressure.

Meanwhile, first-lien issuance rebounded in first-quarter 2025, driven by a pickup in leveraged buyouts (LBOs) and mergers and acquisitions (M&A). Recovery estimates for these new tranches held steady at 64%, in line with the previous two quarters, though still well below historical actual recoveries of 75%-80% and the even lower 72% rate we observed for the five-year period running from 2018-2022.

This report provides a deep dive on private credit default trends and how private loans and BSLs diverge in today's default environment--exploring factors that could potentially shift the dynamics between the two markets, including how a fast-expanding private credit space is narrowing the gap while increasing payment flexibility could push the two further apart.

Access many of the charts and tables in an interactive format here.

Examining The Shifting Default Landscape

About the data

Our main way of tracking the direct lending market is through CEs. Our CEs provide a snapshot assessment of credit quality for middle-market companies whose loans are packaged in middle-market collateralized loan obligations (CLOs) that we rate.

Currently, we have CEs on over 3,100 of these companies. The aggregate value of committed senior first-lien debt and unitranche loans from companies receiving CEs in 2024 is around $800 billion. The default rates we report-–both for CEs and the Morningstar LSTA U.S. Leveraged Loan Index--are calculated by counting issuers rather than weighting by debt amounts.

Private credit expansion drives narrowing default gap with BSL

One major selling point of private credit loans has been their low default rates. However, this reputation hinges on a narrow definition of default, typically covering only traditional defaults, such as missed payments or Chapter 11 filings. It often overlooks instances like conversion of cash pay interest to PIK, amortization holidays, or maturity extensions without adequate offsetting compensation–-events generally considered SDs.

Historically, both default trackers move broadly in sync, although movements in leveraged loan index defaults (which exclude SDs) tend to be more muted. When considering SDs, CE measures tend to lead ahead. This pattern sometimes breaks down during sector-specific cycles. For example, during the oil and gas industry's downturn, volatile energy prices jolted the BSL market because it had greater exposure to oil and gas compared to middle-market borrowers.

Smaller, asset-light borrowers tend to be more vulnerable to credit deterioration during a recession compared to larger peers. Many companies in our CE universe operate in sectors or niches promoted as countercyclical, bolstered by strong cash conversion tied to low capital intensity. We believe a downturn will put this claim to the test, challenging the resilience of these lean, asset-light business.

In drawing comparisons, it is important to recognize each market's own path of evolution. The BSL market took off following the global financial crisis of 2007-2009, ushering in a wave of highly leveraged borrowers and eroding overall credit quality. On the other hand, the CE universe skyrocketed in 2022. As loan sizes grew, the lines between upper middle market and the lower end of the BSL market blurred. The rapid growth in the number of CEs, lower benchmark rates, renegotiated (and consequently reduced) spreads, and stable GDP growth backdrop all played a role in driving down CE defaults in recent months. This brought the CE universe default rate slightly below that of the BSL market.

Additionally, the boom in private lending has made it easier for middle-market firms to secure capital at more favorable terms, especially vital during economic downturns. Not so long ago, even healthy middle market firms struggled to find affordable financing after recession, which kept defaults elevated for a prolonged period. Today, greater availability of affordable funding from private credit helps cushion these same companies against economic shocks, reducing their vulnerability and narrowing the default gap between private credit and BSL borrowers.

The recent spike in market volatility may create new opportunities for direct lenders to regain market share from BSL, especially after some private credit loans were recently refinanced into the syndicated market. In turbulent markets, direct lending stands out for its certainty of execution, though we expect underwriting to become more rigorous in this uncertain environment.

Chart 1

Struggling borrowers act early

Chapter 11 reorganizations have taken a back seat in recent years compared to their prominence in 2008-2009. In 2024, nearly 60% of global corporate defaults took the form of distressed exchanges (typically categorized by us as SDs). In the BSL market, loose documentation terms have made aggressive out of court restructurings increasingly common since they give borrowers and their sponsors substantial flexibility to unlock restricted payments and debt incurrence baskets. A similar trend is unfolding in the direct lending space, where struggling borrowers are actively pushing for flexibility through covenant waivers and amendments.

Private credit borrowers buy themselves short-term relief, often with additional sponsor support as part of the negotiation. Because these measures usually worsen payment terms compared to the original contractual obligations on specific debt instruments rather than the entire debt structure, we classify them as selective defaults (SD), as opposed to conventional defaults (D).

In 2024, SDs in CE outnumbered conventional defaults such as bankruptcy fillings or missed interest or principal payments by a striking ratio of approximately 5 to 1. (Several companies went through multiple SD events last year. When measured by unique entities, the ratio is 4 to 1.) Smaller lender groups (and sponsor relationships) make such transactions easier to negotiate and execute.

Unlike full-scale, bankruptcy-driven restructurings, SDs--including distressed exchanges--often don't resize overburdened debt structures. Instead, they are designed to keep struggling companies afloat. In 2024, a typical cash-to-PIK conversion in the CE space lets borrowers postpone cash interest payments by about one year, matching the median timeline extension for maturity. The main goal is to give troubled companies a supportive path to restore performance or allow a sponsor to explore an asset sale, hopefully increasing the likelihood of full repayment rather than a complete collapse.

Below, we discuss several risk factors that may reshape the default dynamics between private credit and BSL markets moving forward.

Take your PIK

We are seeing growing flexibility in payment terms across both markets-–a trend that could obscure or delay early warning signs of trouble or allow a company to deteriorate even further before triggering a default. Take, for example, borrowers activating a built-in PIK-toggle option: since it does not need explicit lender approval, lenders might miss a valuable chance to tighten protections or close off covenant loopholes, even though the PIK premium comes with enhanced economics. If not structured carefully, these PIK arrangements might leave lenders undercompensated if risks escalate. Moreover, rapidly accumulating loan balances further complicate repayment or refinancing, as growing principal amounts create a steeper hill for borrowers to climb.

Admittedly, today's borrowers with built-in PIK-toggle features are often higher-quality, upper-tier middle market companies. However, while they are less likely to face immediate default risks than their lower-tier peers, the chance for escalation remains. The PIK-toggle feature is also popular for a practical reason, as we observed among smaller entities utilizing recurring revenue loans. It gives companies the option to reinvest cash into the business and grow a subscriber base so that the company can start generating a sustainable EBITDA.

Roughly 2% of the CE universe converted cash pay to partial or full PIK in 2024, representing only a modest share of the total outstanding loans, but this figure is rising and is notably higher than the PIK rate in the BSL market. An overwhelming 90% of these PIK conversions led to downgrades to 'SD'--the need to add PIK flexibility is highlighting unexpected stress.

In our experience, these borrowers often simultaneously battle amortization obligations and lack viable options to raise additional capital. Indeed, approximately 60% of recent PIK events accompanied maturity extensions or amortization holidays. It is also common for mezzanine lenders to agree on fully PIK interest until more senior first-lien debt matures.

Chart 2

Recurring revenue loans see mixed progress on covenant conversions

Within our CE universe, middle market entities in the recurring revenue segment are unique when defining financial covenants. These entities are typically software-as-a-service (SaaS) providers, and their credit agreements test compliance against a recurring revenue leverage covenant (recurring revenue loans).

This covenant replaces EBITDA with annualized recurring revenue in the definition of leverage (see "Rocky Road Ahead For Recurring-Revenue Loans", published June 21, 2023, on RatingsDirect). These deals often test for the recurring revenue leverage covenant until a preset date, referred to as a conversion date or a flip date. After the date, the entity is expected to have scaled up to generate sufficient EBITDA and meet an EBITDA-based leverage covenant. Some credit agreements offer borrower-friendly terms, like a PIK option or amortization holiday prior to the conversion date to help companies preserve cash and reinvest in business growth.

Recurring revenue deals comprise less than 5% of our CE portfolio of over 3,100 entities. We reviewed 85% of the recurring revenue deals to evaluate how these deals perform closer to their conversion timeline (see chart 3). To compare timely conversions, we also added the handful of deals that successfully scaled up and flipped to an EBITDA-based covenant. Of the deals with a mandatory conversion feature, a quarter have entered amendments to delay the conversion by several quarters; a couple have eliminated the conversion requirement altogether, indicating delay or the inability to scale up as initially expected.

Chart 3

4% of middle-market borrowers face shrinking liquidity and narrowing covenant headroom

Currently, 16% of our outstanding CEs have a score of 'ccc+' or lower, topping the 12% seen across the speculative-grade corporate universe. Within this group, about one-quarter also face tight covenant headroom of less than 10%, suggesting potential inability to draw on the revolver, as well as weak debt-servicing ability with adjusted EBITDA interest coverage ratios below 1.2x. Together, all three factors--low entity CE score, narrow covenant headroom, and weak interest coverage--place 4% of the total CE portfolio at heightened risk.

On the upside, sponsors are often willing to step in with additional capital for an underperforming portfolio company when there is a credible chance for turnaround. Furthermore, we've seen no clear sign of sponsor concentration within the most at-risk segment.

Still, lessons from past credit cycles warn that concentration risk-–the reliance on a single customer, contract, or revenue stream–-can blindside companies. Recent defaults in the middle market have stemmed from losing largest customers (representing as much as 19% of revenue), restructuring a major contract that slashes profitability, or facing lawsuits and cybersecurity breaches that have an outsized impact on small, less diversified businesses.

Short bridges lead to repeat defaults

Companies are spending more time in default these days instead of getting rolled off the rolling-12-month default tracker quickly. Among CE companies, 14% that slipped into SD last year had to go through multiple rounds of amendments, each acting as a short-term bridge while management chased a more-comprehensive solution, or sometimes giving sponsors just enough runway to sell the business. In one instance, a borrower deferred interest payments three times before finally arriving at a longer-term amendment solution.

Financial maintenance covenants in private credit are partially driving these repeat amendments. They are doing exactly what they are supposed to: engage lenders early, before the company deteriorates more significantly and while a sponsor may still be willing to provide more support. If a company's performance does not pick up, more talks and more amendments.

On the BSL side, SDs tend to be more complicated and damaging, often involving distressed debt exchanges. Loose loan documents open doors to convoluted and disruptive debt reshuffles outside of bankruptcy court, creating varied recovery outcomes among the same group of lenders.

Yet these maneuvers brought little respite. Based on our review of 42 aggressive non-pari liability management transactions by 39 companies from mid-2017 through 2024, 33% of those firms still ended up filing for bankruptcy and another 56% have either subsequently re-defaulted or are deemed more likely to default than not.

Private credit braces for downstream blow from tariff

Private credit borrowers generally have limited direct exposure to tariffs, given their predominantly domestic business focus. The downstream effects are more impactful-–particularly the potential slowdown in consumer and corporate discretionary spending. Businesses may cut back on advertising or promotional campaigns in response to increased costs, and some U.S. demand is permanently lost at higher price levels. The complete effects might take some time to surface, as companies tend to stockpile inventories in anticipation of tariff-related price hikes. Some companies, like health care services companies, have to take on prices, as they have limited ability to pass on rising input costs.

Outside of tariffs, industries like homebuilding, engineering and construction are also sensitive due to their heavy reliance on immigrant labor. It's also worth noting that middle-market CLOs vary widely in how concentrated they are within these sectors.

Earnings Cushion Against Tariff-Driven Volatility For Speculative-Grade Issuers

Annual financials for 2024 are still trickling in, but initial data from 750 firms suggests that the fundamentals of speculative-grade companies in the U.S. and Canada, both public and private, remain solid. On an aggregate basis, median reported EBITDA edged up 0.8% between 2024 and the 12 months through September 2024, with margins holding steady. Overall, 54% of issuers boosted trailing-12-month EBITDA last quarter, and 20% of the total managed to log four consecutive quarters of 12-month EBITDA growth.

Even smaller firms demonstrated strength. Tracking the 100 smallest entities (EBITDA below $100 million as of year-end 2022, where 37% carry a 'B-' rating) show that they've turned in respectable profit gains since 2022, despite some slowdown in the most recent period. For firms rated 'B-', EBITDA interest coverage also improved 0.2x in 2024, thanks in part to savings from last year's repricing and refinancing wave. A slight dip in free operating cash flow (FOCF) to debt mostly reflected bigger investments in working capital rather than any worrisome shifts.

In terms of sectors, forest products/building material/packaging companies suffered major pressure on profit margin. Meanwhile, profits for capital goods/machine and equipment and consumer products sectors have only recently started to soften.

Given private companies' longer reporting timelines, our current dataset of 750 firms is smaller than our usual sample of over 1,000, particularly among lower-rated issuers. Specifically, the count of 'BB' category companies remained steady, but the 'B' category shrank by around 39%. While this introduces a modest upward bias in our metrics, we don't believe it changes the overall story and underlying trends.

First-Lien New-Issue Recoveries Hold Steady Amid LBOs And M&A Rebound

First quarter of 2025 kicked off with a substantial amount of repricing and refinancing activity, continuing the momentum from 2024 as spreads hit multidecade lows. Among them were two sizable shifts from private credit to the BSL market--a $2.5 billion term loan refinancing for Avalara Inc. and a $3.18 billion refinancing for Kaseya Inc. Following three years of subdued transaction activity, we saw some revival in LBO and M&A deals during the quarter, along with a rise in dividend recapitalizations as sponsors used this avenue to return capital to investors.

As higher deal volumes outpaced the past two quarters, the average recovery estimate for newly issued first-lien debt in first-quarter 2025 held steady at 64%. Additionally, we saw a higher proportion of first-lien issues with a '2' recovery rating, largely from issuers rated 'B+' and higher, with meaningful layers of junior unsecured debt supporting the recovery of the first lien.

We measured quarterly trends in our recovery expectations for first-lien new issues using average recovery point estimates. Starting in 2024, we excluded new issuance arising from restructuring debt exchanges to minimize reporting bias.

Chart 4

Appendix

Table 1a

Table 1b

Table 1c

Table 2a

Table 2b

Table 2c

Table 3a

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Table 3c

Table 4a

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Table 4c

Table 5a

Table 5b

Table 5c

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Table 6c

Related Research

• 2024 Annual Global Corporate Default And Rating Transition Study, March 27, 2025
• The U.S. Speculative-Grade Corporate Default Rate Could Fall To 3.5% By December 2025, Feb. 20, 2025
• Systemic Risk: Private Credit’s Characteristics Can Both Exacerbate And Mitigate Challenges Amid Market Evolution, Feb. 18, 2025
• U.S. Leveraged Finance Q4 2024 Update: Outperforming Private Credits Thrive After BSL Transition, Jan. 31, 2025
• Private Credit And Middle-Market CLO Quarterly: Waiting For The Sun (Q1 2025), Jan. 24, 2025
• U.S. Leveraged Finance Q3 2024 Update: Sponsor-Backed Companies Experiencing Highlights And Lowlights, Oct. 30, 2024
• Demystifying Loan Liability Management Transactions And Their Impact On First-Lien Lenders, Oct. 30, 2024
• Documentation, Flexible Structuring Continue To Reign In Private Credit, Sept. 17, 2024
• Rocky Road Ahead For Recurring-Revenue Loans, June 21, 2023