Default rates in direct lending will climb to 8% as advances in artificial intelligence continually disrupt the software industry, according to Morgan Stanley.
While AI disruption has yet to impact private credit fundamentals in a “material way,” elevated leverage and looming maturity walls within the software sector may push default rates near peak levels unseen since the pandemic, a team of analysts including Joyce Jiang said in a Monday note.
“Credit fundamentals of software loans are challenged with the highest leverage and the lowest coverage ratios across major sectors,” the strategists wrote. While defaults have moderated across public and private loan markets, they added, defaults are only set to climb further as AI disruption unfolds.
Global credit markets have come under pressure in recent months as investors assess how AI will cut into revenue streams of software companies. Alternative asset managers had spent the last decade piling into software firms, drawn by predictable earnings and higher margins.
Morgan Stanley says software is the largest sector in business development company portfolios, with exposure at roughly 26%. Private credit collateralized loan obligations, which securitize middle market loans, have about 19% of their portfolios in software, the strategists said, with many of those loans coming due soon.
The maturity wall is “front-loaded for software loans in direct lending,” with 11% of such loans slated to come due in 2027, followed by another 20% in 2028, the strategists said, citing PitchBook data.
Default rates in direct lending last approached 8% in 2020 when the COVID-19 pandemic rattled the global economy, though they recovered relatively quickly and now hover in the mid-single digits, according to Morgan Stanley. Some strategists see even more potential downside in the asset class: last month, UBS Group AG strategists warned that private credit could see default rates surge as high as 15% in a worst-case scenario where AI triggers an “aggressive” disruption among borrowers.
Angst around the sector has pushed redemption requests in private credit funds higher, as managers debate the appropriate way to handle all the investors looking to pull out their money. Just last week, Morgan Stanley and Cliffwater LLC capped withdrawals from their multibillion-dollar private debt funds after investors sought to redeem well-above the standard quarterly threshold.
To be sure, the strategists argue that while the broader risks in private credit are significant, they are not systemic, and pose limited danger of spillover to the wider market.
Business development companies, which let retail investors access private credit investments, were holding $530 billion in assets as of the third quarter last year. That has led to concern that private credit’s inherent illiquidity may hurt less sophisticated investors and put a damper on one of the main sources of recent growth in these markets.
“The moderation of retail demand for private credit can shift the buyer base composition more towards institutional and temper the growth of private credit going forward,” the strategists noted.
Written by: Rene Ismail and Emily Graffeo @Bloomberg
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