From defaults to deals: What the credit markets are actually telling us

Headline default rates suggest stability, but beneath the surface of private credit, stress is accumulating through delayed restructurings, optimistic valuations, and growing refinancing pressure. Matthias Kirchgaessner, Managing Partner, PLEXUS Research, outlines the key themes shaping the distressed opportunity set today, questions that will be explored in depth at the Private Debt Summit at SuperReturn International this June.

Headline default rates of 2–3% across bond and broadly syndicated loan markets suggest a remarkably calm credit environment. But are defaults really the right barometer for the health of the broader credit ecosystem, particularly in direct lending, which now dominates the private credit complex? A deeper look underneath the hood tells a more complicated story.

As moderator of the Opportunistic Credit and Distressed Panel at the Private Debt Summit in Berlin, I keep asking managers who operate in the trenches daily the same question: where is the real stress hiding, and what is quietly building beneath the surface? Last year, managers were getting excited about the looming opportunity set. This year, the mood has shifted from anticipation to urgency, and the questions I am bringing to Berlin reflect that change.

Where is the real stress hiding, and what is quietly building beneath the surface?
Matthias Kirchgaessner, PLEXUS Research

LMEs: Elegant transitional capital or a bridge to nowhere?

Liability Management Exercises (LMEs) have become a defining feature of this cycle in the last couple of years, and their rise is far from accidental. The root cause is structural; with covenant-lite loans now exceeding 90% of leveraged loan issuance in the upper-middle market, and meaningful maintenance covenants absent across most large private credit loans, sponsors have gained broad contractual flexibility. In 2025, LMEs and distressed exchanges accounted for 48% of total annual default and distressed volume, marking the third-largest annual total on record [1]. This tool is not going away.

The debate now centres on what LMEs actually accomplish. Some describe them as “elegant transitional capital,” a bridge that buys time without fixing the underlying capital structure. Others push back and argue that a well-executed LME can preserve optionality for businesses that genuinely need runway. The data make the first camp’s case harder to argue with. According to JPMorgan's research, roughly 50% of LMEs result in a hard restructuring within two years, and approximately 75% eventually end in one. Since 2008, about 41% of companies engaging in distressed exchanges have returned to the market with another default action [2].

The tool is not going away.
Matthias Kirchgaessner, PLEXUS Research

A recurring panel question is who truly benefits from this dynamic. It is one I intend to put directly to managers in Berlin.

The value destruction embedded in this process is now visible in recovery rates. By enabling overleveraged companies to continue operating with weak governance and poor capital allocation, LMEs systematically erode the asset base creditors ultimately recover against. In 2025, first-lien senior secured recoveries fell to all-time lows of 36–44 cents on the dollar, versus a 25-year average of roughly 62%.

The pricing dislocation this creates is one of the more dangerous features of the current market. Loans supported primarily by sponsor confidence may trade at 80–85 cents, only to gap down to 50, 30, or lower almost overnight once sponsor support weakens or a restructuring triggers forced selling. At that point, marked-to-market becomes unavoidable, and reality arrives through executable pricing.

The 80-to-30 cliff: When sponsor support runs out

One of the burning topics I will raise at the panel - and one that distressed managers and allocators increasingly flag as underappreciated - is the illusion of stability in reported private credit portfolios.

I have written about this concern before, including in the PDI June 2025 issue (“Hidden Risk in Direct Lending”). “Mark-to-myth,” as I call it, is no longer a fringe concept. We are seeing more cases where credits appear healthy at 80 cents on the dollar as long as sponsors continue to inject equity, waive covenants, or extend maturities via PIK features. The moment sponsor conviction fades - or a fund hits its own liquidity limits - the valuation floor disappears quickly.

This is no longer hypothetical.

Mark-to-myth, as I call it, is no longer a fringe view.
Matthias Kirchgaessner, PLEXUS Research

The practical implications for institutional portfolios are stark. A direct lending book marked at 98 cents NAV today carries significant downside risk as refinancing pressure builds or liquidity forces transactions. The 2027–2028 maturity wall is not an abstract concept. It is concentrated in loans originated at peak-cycle multiples in 2021 and 2022 [4], characterised by thin EBITDA margins, limited covenant protection, and now facing refinancing into a materially different rate environment. That combination has not yet been stress-tested in a higher-for-longer rate environment.

Software credit risk: The next energy crisis, but bigger

The sector I expect to generate the most debate at the panel is software - and for good reason. Today’s concentration of software and technology exposure across leveraged credit markets exceeds the scale of energy exposure during the 2015–2016 oil and gas crisis. This time, however, the exposure is roughly twice as large.

Within BDC portfolios alone, software and tech represent 26–28% of total exposure [5]. That is not diversification - it is concentration risk.

In BDCs alone, software and tech account for 26-28% of total portfolios.
Matthias Kirchgaessner, PLEXUS Research

Much of today’s problem traces back to the 2021 vintage. Software debt originated against a backdrop of zero interest rates, record leverage, and a market consensus that SaaS recurring revenue was essentially bulletproof. Many of those capital structures are now upside down. The latest Morgan Stanley credit research indicates that nearly 20% of the software loan universe already trades below 70 cents on the dollar, before fully reflecting AI-driven pressure on terminal values [6]. Furthermore, a deeper downturn could push BDC default rates into the 9–12% range, well beyond most LP base-case assumptions.

Technical pressure is already evident. CLO managers are actively reducing software exposure to avoid breaching Triple-C concentration limits, typically around 7.5%, beyond which equity cash flows shut off [7]. That selling pressure has driven price dispersion across loan markets in ways that are not yet widely understood. The deeper problem is visibility. Unlike public markets, software exposure in leveraged credit is overwhelmingly private and sponsor-backed. The real impact of competitive and technological disruption often remains hidden until decisive action is no longer possible.

What distressed managers are buying: The HALO framework

Across conversations with active distressed managers, a consistent framework has emerged: HALO - Hard Assets, Low Obsolescence.

This approach prioritises underwriting the downside. Hard assets provide a tangible recovery floor. Low obsolescence reduces the risk that terminal value evaporates due to technological or competitive change. For many managers today, zero software exposure is not a missing allocation - it is an intentional strategy.

So what does that look like in practice? In commercial real estate, managers are targeting A-plus-quality assets at generational discounts: prime office locations in Germany with government tenants, trophy hotels, and multifamily assets in London. The dislocation is not about asset quality. It is about forced sellers, banks, open-ended funds, and over-leveraged sponsors all facing liquidity pressure simultaneously.

Similar dynamics are drawing capital into infrastructure and power, where assets offer physical substance, contracted revenues, and long-dated relevance that is easy to overwrite. Beyond real assets, managers are also active in “old economy” corporates - manufacturing, industrials, building materials, and packaging - as well as bankruptcy and litigation claims that offer uncorrelated return potential. Structured credit dislocations are another area of focus, with opportunistic buyers waiting for gap-down moments that justify entry.

The common thread is clear: assets with visible recoveries, durable business models, and motivated sellers unrelated to underlying quality.

The cycle ahead: A long grind with fat tails

We are not at the beginning of this cycle, but we are far from the end. There will likely be no Lehman-style moment. Instead, credit stress is unfolding as a slow, multi-year process of recognition. The gap between reported and realisable credit quality will narrow as maturity walls approach, sponsor patience thins, and auditors and ratings agencies begin to catch up.

We are not at the beginning of this credit cycle, but we are far from the end.
Matthias Kirchgaessner, PLEXUS Research

Approximately $580 billion of US high-yield and leveraged loan maturities come due between 2027 and 2029, with a heavy concentration in lower-rated, covenant-lite 2021-vintage paper [8]. The refinancing math simply does not work for the weakest cohort. A base case of 5–6% annual default rates over the next two to three years, with fat and ugly tail outcomes beyond that, should not be dismissed.

First-lien recoveries are already at historic lows. Mark-to-myth only works - until it doesn’t.

Historically, the best distressed entry points arrive two to three years after the initial rate shock. That window is now opening. These are the observations I am bringing to the SuperReturn Distressed Panel in Berlin this June. The questions that matter most remain unresolved: How do you position for a cycle everyone can see but no one can precisely time? And which scenario remains underappreciated—even by well-prepared managers?

I intend to find out. I hope you will join us.

Executive takeaway

Headline default rates are masking growing stress in private credit.

• Risk has been deferred through covenant‑lite structures, LMEs, and sponsor support, but the coming refinancing cycle will force recognition.
• Valuation stability, sector concentration - particularly in software - and recovery assumptions matter more now than headline yield or reported NAVs.

For GPs: The next phase of the cycle will reward realism- active sector management, defensible valuations, and a focus on recoverability as refinancing pressure replaces financial engineering.

For LPs: Portfolio outcomes will hinge less on stated returns and more on liquidity, refinancing risk, and the gap between marked values and executable prices as the maturity wall approaches.

Matthias Kirchgaessner is a private debt and credit specialist at Plexus Research, an LP advisor, and an active member of the global private credit community. He regularly moderates private credit conferences, including the upcoming Distressed Panel, Private Debt Summit at SuperReturn International in Berlin.

References:

[1] J.P. Morgan Default Monitor, February 2, 2026, p.3
[2] J.P. Morgan Default Monitor, February 2, 2026, p.9
[3] Fitch Ratings, U.S. Private Credit Default Monitor, March 6, 2026
[4] Morgan Stanley Corporate Credit Chartbook, April 1, 2026, p.35
[5] Morgan Stanley Private Credit Tracker 4Q25, March 16, 2026, p.8
[6] Morgan Stanley “Mapping Software Exposure in Leveraged Credit” Global Foundation, February 9, 2026, p.3
[7] Morgan Stanley “R-AI-sing Dispersion in CLOs” Global Idea, February 20, 2026, p.4
[8] PitchBook LCD via PitchBook News, December 10, 2025