Private Credit Rocked By UBS Shock Outlook: Record "Cascading Defaults" And Widespread Contagion

Around the time we reported on private credit's massive exposure to software one month ago, which sparked a fresh, and even more furious, selloff in private credit stocks and especially Blue Owl which has since gone on to gate retail investors in one of its main funds, UBS's head of credit strategy at UBS Investment Bank Matthew Mish was busy laying out a worst-case scenario for defaults, disruption and dispersion in private credit (note available to pro subscribers), which was already especially dismal. Overnight, his outlook just became outright apocalyptic

Exactly one month ago, on January 25, Mish and his team warned that while near-term default risk may be moderating, structural pressures are rising, and "while refinancing risk and liquidity conditions remain manageable, defaults are likely to rise ~2% as prior  restructurings and the effects of AI-driven disruption work through the system."

Worse the UBS strategists accused credit market of being slow to price in the "fundamental bifurcation that is emerging across sectors." Yet, as we have since observed from a front row seat, Mish warned that the most material risk is not a cyclical downturn - the traditional trigger to credit market instability - but "AI-driven disruption to leveraged technology and business services models, with potential spillovers into leveraged loans (LL)."

Fast forward to today when default risk is no longer moderating, but is accelerating, and as Mish writes in his Tuesday note ("AI disruption and private credit: what is the risk scenario" also available to pro subscribers) he now expects a private credit default rates to surge to 15% - two percent higher than his previous forecast just a month ago and a record high, which is not saying much for an asset class that did not exist more than a few years ago- due to "rapid, severe AI disruption" which was the tail-risk case in UBS previous assessment but has become the only thing the bank's clients want to talk about and is increasingly becoming Mish's base case. Indeed, in his latest update, the UBS analyst writes that while the bulk of his outlook hasn't changed, and was largely published back in November, what is new is a clearer catalyst "rapid, severe AI disruption." 

Here are the key points:

1. First, in a tail scenario, assuming contagion impacts not modelled in the previous UBS note, we anticipate US HY, LL and PC defaults could rise to 3-6%, 8-10% and 14-15%, respectively. Across these three markets defaults and losses would approach $420bn and $300bn, respectively.
2. Second, in this extreme case, regression analysis suggests US IG, HY and LL spreads could trade to 160-170, 575-675 and 800-900bp, respectively.
3. Third, credit availability will tighten materially, particularly for firms dependent on leveraged finance markets - PC and LL issuance could decline 50-75% YoY.
4. Lastly, financials will be impacted through several channels. One is NFBI loans, currently $2.5tn including all undrawn commitments. In a tail scenario, UBS estimates $1.6-1.8tn in total drawn exposures, of which about 30-40% is to private equity/credit/BDCs or SPVs/CLOs/ABS and we would consider higher risk.

All of this comes just days after Blue Owl Capital, which has extensive exposure to software loans, blocked investors from making withdrawals from one of its private credit funds (see "The "Canary In The Coal Mine" Just Froze: Here Is What Is Really Happening At Blue Owl") making UBS's tail risk scenario far more likely and raising anxiety about the loans issued by direct lenders, especially to software firms which as we reported previously represent as much as 45% of Blue Owl's Technology Income Corp (OTIC) book.

As Blue Owl's gated investors know all too well, while default rates remain contained so far, UBS warns that stress indicators are rising, with private credit defaults reportedly between 3% and 5%, and signs of strain - such as interest paid-in-kind or PIK - nearing post-pandemic highs. Meanwhile, leverage ratios have crept higher, with debt-to-EBITDA reaching 7.5–8x in some sectors.

While interest coverage ratios have ticked higher, they remain under pressure from elevated rates, with middle-market deals hovering in the 1.7-1.8x range. Mish writes that "these metrics suggest that while the market is not in crisis, it is increasingly kicking the can down the road and vulnerable to macroeconomic deterioration, sectoral disruptions or liquidity shocks."

Taking a step back, while accelerating AI disruption is clearly the trigger for the coming Private Credit calamity, the "most acute risk is a sector-specific shock triggering cascading defaults" UBS writes. Historical precedents, such as telecom in 2001 and energy in 2016, show how concentrated defaults can drive market-level default rates. One sector can account for 55-80% of market level defaults: as regular readers know, today’s private credit portfolios are heavily weighted toward services (25–30%), technology (20–25%), and healthcare (15–17%).

Technology is especially vulnerable to disruption from AI adoption or rapid retrenchment. These risks are compounded by weakening covenants, aggressive earnings adjustments, and opaque valuations. Shockingly, first-lien recoveries in syndicated loans recently fell to the mid-50% range and as low as 30% for energy in 2016, indicating reduced downside protection.

Making matters worse, once the contagion begins, it won't stop until it infect the broader credit space. As UBS writes, "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, Mish writes, "means that a spike in private defaults could ripple across public markets, widening spreads and impairing liquidity."

Ever hear the saying "If you owe the bank $100, that's your problem; if you owe the bank $100 million, that's the bank's problem." Well, private credit owns the banks over $1 trillion, and suddenly they have a huge problem. Over the years, banks and insurers have quietly built substantial exposure to private credit and alternatives: US and European banks hold $1.3 trillion in loans and ~$1.1 billion in undrawn commitments to non-bank financial institutions (NBFIs), with GSIBs accounting for 60% of the total. Making matters worse, the fastest-growing categories include loans to SPVs, CLOs and ABS, closed-end investment and mutual funds, and private equity/credit funds and BDCs. Life insurers, specifically those linked to PE sponsors, have increased allocations to private credit and structured products, often relying on internal ratings.

To UBS 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 concludes his latgest 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.