Credit Markets Finally Crack As Private Credit Contagion Infects Public Markets

Back in October, when there were curiously little concerns about the public credit markets' exposure to the AI bubble, and very few had considered the massive exposure of the Private Credit market to the rapidly disrupted Software sector (which according to some accounts for as much as 35% of PC loans), we warned readers that "AI Is Now A Debt Bubble Too, Quietly Surpassing All Banks To Become The Largest Sector In The Market."

As we pointed out back then, according to JPMorgan, AI-related companies make up 14% of the Investment Grade Index with $1.2T in debt. Shockingly, this is now the largest sector within the IG index, exceeding Banks.

And while spreads back then were rock solid, concerns were already emerging about the stability of the credit sector. This is how JPM credit strategist Eric Beinstein described it: 

The torrid ascent of AI stocks has caused some angst for credit investors worried that any potential downside there could have credit implications. We think that from a fundamental perspective, these fears are not justified as these companies are either cash rich/not highly levered (Tech and Cap Goods) or highly regulated (Utilities). That said, an equity selloff in AI-related names would likely impact credit too, and, given these companies trade tight to the rest of the market, a short basket of single name CDS may be an effective tail-hedge for cross-asset investors.

In conjunction with JPM HG Credit Tech, Utilities and Cap Goods analysts, we have identified what we believe to be the current cohort of IG companies most closely tied to the AI revolution. The amount of debt tied to these companies has grown rapidly to $1.2tr currently. As such, AI companies as we define them now make up 14.0% of the IG index, which if thought of as a ‘sector’ is now larger than the largest HG sector (US Banks).

Fast forward 4 months to today, when the bond market is finally starting to crack: investment-grade bond markets, which for years had served as a safe haven during the recent AI-driven swings in equities, are starting to widen rapidly amid unmistakable signs of strain. And nowhere is this more visible than the chart showing the delta between Investment Grade tech spreads and the broader IG index. For the first time since the global financial crisis, tech is viewed as less solid than the broader index.

Another way of visualizing the latest blowout in tech spread - and underperformance relative to the broader IG sector - which is rapidly following the Liberation Day path, is shown below.

The credit crack is not just in the US: as Bloomberg notes, yield premiums on Asian investment-grade dollar notes were about two basis points wider Friday, as weekly spreads climbed by the most since November.  This is notable as Asia (read Korea and Japan) has been relatively immune to the disruption fears that have rocked US markets in recent months. “Valuations in the Asian market have tightened in sync with developed markets like the US, and we will not be immune to volatility there,” said Clement Chong, head of credit research for fixed income at Eastspring Investments.

Globally, premiums on comparable debt have already widened by nearly 4 basis points this week, the largest move since early November, according to a Bloomberg index, as more investors finally realize that tech has become a ticking IG time bomb - as we warned in October - and that AI could increase default risks across parts of the software sector, particularly among more leveraged borrowers. 

In other words, it's not just a Private Credit risk any more: public markets are suddenly all too exposed as UBS warned earlier this week. 

Despite the recent moves, swings in high-grade credit gauges - sparked by concerns about sky high valuations, fears about a possible return of inflation, and AI-related risks - have been modest compared with the sharp gyrations in equity markets and riskier parts of credit. Investment-grade corporate risk premiums have widened about 8 basis points over the last month to 82 basis points. That remains well below the 10-year average of 119 basis points, according to a Bloomberg index.

But while the move in investment grade remains contained, even if it is now a historic inversion for tech, one can't say the same for junk where the blow out in tech spreads - now at over 2 year wides - is far more spectacular.

The rout in junk - which came after Thursday's issuance scramble as five deals (Sirius XM, Sunoco, Chemours, Matador Resources and CACI International) priced totaling $4.4 billion, the most in 5 weeks as investors rushed to sell debt while they still can - comes as high-yield bonds are poised to post a 10th-consecutive monthly gain for February, according to a Bloomberg index, extending the market’s longest such run in nearly five years. But that is about to end as investor concerns about the software sector are translating into selling. Meanwhile, US junk-bond funds have had outflows each of the past three weeks, according to LSEG Lipper data.

And then there is the leveraged loan market, where the wheels have come off for the tech sector, which is falling faster than the broader Leverage Loan index in the US and Europe, as UBS credit strategist Matthew Mish pointed out recently.

The collapse of the UK mortgage-finance company Market Financial Solutions this week has only added to concerns over loose underwriting in credit markets, as speculation that billions in assets may have been rehypothecated - again - has shaken markets.  Last year, the bankruptcies of US auto parts supplier First Brands Group and sub-prime auto lender Tricolor Holdings unsettled Wall Street.

And while public markets are getting hit, the epicenter of the next credit crisis will originate in private credit. As we discussed earlier this week, once the contagion begins, it won't stop until it infect the broader credit space. As Mish wrote, "private credit stress is unlikely to remain contained. Borrowers increasingly tap both private and syndicated loan markets, with overlapping issuer and sector exposures and shared sponsors. Services and tech represent 15–20% of leveraged loan portfolios, mirroring private credit."

Meanwhile, on the lender side, the top 20 direct lenders not only dominate private credit AUM but also hold significant stakes in BDCs (45%), leveraged loans (20%), and high-yield bonds (25%).  These are the same lenders that Jamie Dimon was raging against yesterday. This interconnectedness, UBS wrote, "means that a spike in private defaults could ripple across public markets, widening spreads and impairing liquidity."

To the UBS strategist, all this "raises concerns about capital adequacy and loss absorption in a downturn, particularly if defaults spike and valuations collapse." In short, once the private credit trigger hits, the contagion will be fast, brutal and will culminate with yet another Fed bailout . 

As Mish concluded his latest note, the private credit market is not in crisis - yet - but the ingredients are present for a severe credit cycle. The key trigger is a shock to one of the key sectors, like - for example - software. Meanwhile, size, leverage, sector concentration, and opacity all raise potential systemic risk, but limited transparency and disclosure make a proper calibration of macro risk challenging. That's why investors must monitor leading indicators - defaults, PIKs, covenant breaches, and valuation marks at market and sector levels -while demanding better disclosure and underwriting discipline. Which they won't as most investors still rely on other investors to do their homework for them..

For their part, policymakers and regulators should assess the implications of bank and insurer exposures, especially as private credit increasingly becomes a core funding source for high-growth sectors. Which they also won't, as they rely on corrupt and coopted rating agencies to do their homework for then.

UBS' bottom line "Our analysis across banks, insurers, and BDCs globally suggests a wide range of private and alternative exposures could be impacted if we enter a private credit downturn."

Much more from UBS in Matthew Mish's latest note, and January note, available to pro subscribers.