Credit Cycle at the Crossroads: Spread Re-Pricing, Sector Bifurcation, and the New Underwriting Imperative

Market Headline: Price Discovery Returns as Late-Cycle Signals Multiply

The first quarter of 2026 brought a decisive shift in the tone of both public and private credit markets. After two years of tight spreads, compressed yields, and borrower-friendly terms, the market is now in an active phase of price re-discovery.
Heightened volatility in early 2026, driven by AI-related disruption concerns and geopolitical developments, pushed credit markets back into price discovery mode.
In the first quarter of 2026, private debt markets have entered a renewed phase of price discovery, navigating a more challenging and volatile backdrop, shaped by several notable developments: a sharp selloff in software and technology services in loan, bond, and equity markets, driven by concerns that new AI tools could disrupt existing business models.

The macro backdrop has compounded these sector pressures.
The geopolitical situation in the Middle East contributed to volatility in oil and oil-based products, increasing upside risks to the inflation outlook and complicating the Federal Reserve’s policy path for the remainder of 2026.
Simultaneously, bank credit conditions are tightening at the institutional level:
The April 2026 SLOOS reported that, over the first quarter, survey respondents reported, on balance, tighter lending standards and basically unchanged demand for commercial and industrial (C&I) loans to firms of all sizes.
Notably, the April 2026 survey broke new ground by interrogating non-depository financial institution (NDFI) lending:
Banks reported, on net, tighter standards for all categories of NDFI loans over the past year, with significant net shares reporting tighter standards for business credit intermediaries, consumer credit intermediaries, and other NDFI loans, and moderate net shares for mortgage credit intermediaries and private equity funds.

Against this backdrop, the structural growth story for private credit remains intact.
The private credit market has reached a pivotal stage in its growth, with direct lending now matching the broadly syndicated loan market at $1.5–2 trillion in size and forecast to reach $3 trillion by 2028.
However, the path forward is no longer uniformly constructive:
As private credit moves into the later stage of the credit cycle, competition can increase the risk of aggressive underwriting and weaker covenant protections, factors that could lead to a deterioration in credit quality in the direct lending market.

Quantitative Snapshot: Key Market Metrics, Q1 2026 vs. Prior Period

The data paints a coherent picture: while headline default rates remain contained relative to long-term averages,
the distressed ratio, after hovering in the 4–5% context for much of 2025, gradually increased in the fourth quarter of 2025 and reached 8.89% in February 2026, in line with peak months since interest rates started rising in 2022, and a trend worth watching closely.
Meanwhile,
by March 2026, deal volumes were 42.4% lower than January levels, following a modest reopening in the second half of 2025 and early 2026.

Sector Analysis: Bifurcation Accelerates Across the Credit Landscape

🔴 Sectors Under Pressure: Software, Technology Services, Office CRE

Technology and software services loans continue to price at wider-than-average premiums given risk-off conditions and lower implied enterprise values, which have driven higher loan-to-value ratios quarter-over-quarter, leading lenders to evaluate AI-impacted borrowers on a case-by-case basis.
The problem is structural as well as cyclical:
Private credit funds can have sizable exposure to the software sector, with software credit often comprising 20% to 30% of fund assets, far larger than software’s representation in public markets, where it makes up just 5% of the US high-yield universe.
The absence of hard-asset collateral compounds the risk:
While the software sector has historically been viewed as an ideal private market mainstay given its high margins, recurring revenues, and predictable cash flows, limited hard asset collateral means that in the event of a credit default, investors can often recover only a small fraction of their investment.

On the real estate side,
private credit lenders are retreating from office property exposure as uncertainty around future demand intensifies; questions around office usage, compounded by technological and workplace changes, are influencing lending decisions, and private credit appetite for office assets has diminished relative to other property and infrastructure-linked segments.

Healthcare is another sector flagged for caution:
Morgan Stanley maintains a significant underweight to healthcare, which has led all sectors in loans placed on non-accrual status over the last year.
Divergent borrower performance across certain segments persists, with healthcare, specifically within the physician practice management space, showing weaker performance as both the cost and availability of labour have put short-term pressure on margins and cash flow.

🟢 Sectors with Strong Lender Appetite: Infrastructure, AI Capex, Asset-Based Finance

In infrastructure, private credit is being used to fund large-scale projects such as renewable energy developments and, increasingly, infrastructure related to artificial intelligence, including data centres and power grid upgrades.
The magnitude of the opportunity is striking:
JPMorgan reports that US data centre-related bond issuances reached $15.1 billion in 2025, and estimates that around $150 billion will be needed in 2026–27 to convert short-term construction loans into long-term financing for nearly 20 gigawatts of data centre capacity.
Additionally,
US utilities are increasingly engaging with private credit providers as they prepare for significant capital investment programs, facing growing spending requirements tied to infrastructure build-outs and rising power demand, and traditionally reliant on public markets, some are now exploring private credit as a supplementary funding source.

Asset-based finance has emerged as the largest structural growth opportunity:
Asset-based finance is now larger than all other private credit markets combined, with structural tailwinds including bank retrenchment, insurance demand for rated assets, and AI and data center financing needs likely to accelerate growth in 2026.
The insurance sector’s role as capital provider is also a major structural shift:
Nearly one-third of US insurer assets are now allocated to private credit, almost $2 trillion of the $6 trillion in US insurers’ invested assets, driving demand for rated structures, collateralized fund obligations, and rated note feeders.

Regulatory Tailwind and Bank Competition Dynamics

A significant regulatory development reshapes competition at the top of the market:
On 5 December 2025, the OCC and FDIC issued a joint statement rescinding the March 2013 Interagency Guidance on Leveraged Lending, expecting institutions to manage leveraged lending exposures consistent with general principles for safe and sound lending, allowing lenders to make their own determinations of risk appetite and giving private credit lenders greater flexibility to underwrite a broader range of loans.
However, banks are simultaneously competing more aggressively in the large-cap space:
Banks have demonstrated their continued relevance in large-cap financing (JPMorgan’s recent $20 billion acquisition financing for Electronic Arts exemplifies their enduring capability to underwrite and syndicate jumbo transactions) retaining advantages in balance sheet capacity, established syndication networks, and pricing that can undercut private credit when market conditions permit.

Implications: What This Means for Borrowers, Lenders, and Investors

For Borrowers and Operators

The era of easy terms is drawing to a close.
For several years, the private credit industry was characterised by borrower-friendly terms, covenant-lite structures and aggressive leverage multiples were common as lenders competed to deploy record levels of dry powder. In 2026, the pendulum has swung back.
The FCCR is now a primary underwriting lens, not a secondary one:
The real standard that most lenders focus on (and investors should direct their attention to) is the Fixed Charge Coverage Ratio (FCCR). While being a useful proxy, Interest Coverage Ratio can obscure more than it illuminates, relying on an Adjusted EBITDA figure that does not answer the most critical question for every credit investor: Is this company generating enough free cash flow to service its debt?
Borrowers must also contend with EBITDA add-back scrutiny:
EBITDA add-backs complicate FCCR further: restructuring charges, projected cost savings, and acquisition synergies can inflate the numerator materially, with add-backs that represent 30% or more of reported EBITDA not unusual. When adjustments become large relative to actual earnings, the covenant loses its early-warning value.

For operators facing refinancing pressure from 2021 vintage loans,
private credit lenders are no longer willing to “extend and pretend” without significant equity injections or structural enhancements.
According to McKinsey & Co., more than $620 billion in high-yield bonds and leveraged loans are set to approach maturity in 2026–2027, which could create refinancing opportunities but also spur greater demand for private credit solutions.

For Institutional Investors and Lenders

Performance dispersion across managers will be the defining characteristic of 2026.
Across multiple rate cycles, private credit has delivered 200–400 basis points of excess return over liquid credit markets, reflecting compensation for illiquidity, structural protections, and active underwriting.
But in the current environment,
outcomes depend on managers: underwriting quality, portfolio construction, and restructuring capabilities can lead to meaningful dispersion across managers.
Covenant terms are the critical differentiator:
Middle market loans have exhibited an average spread premium of 1.1% over large corporate loans since 2008, and through 3Q25, nearly half of middle market deals had two or more covenants compared to only 10% for larger transactions, producing a more attractive return profile with stronger risk mitigants.

Year to date, business development companies (BDCs), a proxy for lower-tier direct lending, have underperformed meaningfully, while broader public credit markets, including high yield and leveraged loans, have remained relatively stable: suggesting pressures are largely confined to lower-quality segments, particularly middle market sub-investment-grade direct lending, rather than reflecting a broad deterioration in credit fundamentals.

Forward-Looking View: The Next 3–6 Months

Over time, new deal demand together with a large refinancing wave is expected to gradually overtake private credit supply, creating an imbalance that allows lenders to preserve discipline, strengthen terms, and capture the illiquidity premium to public markets.
On the retail and institutional capital-raising front,
US retail allocation to private credit currently stands at roughly $0.1 trillion but is projected to grow at an annualized rate of nearly 80% to reach $2.4 trillion by 2030, with interval fund assets having grown to nearly $450 billion by mid-2025, a 16% increase from year-end 2024.
The FSB’s May 2026 vulnerability report signals that systemic scrutiny is intensifying:
Reporting highlights growing regulatory and market attention on how private credit exposures held by banks and insurers could transmit risk within the financial system.
Investors should expect further transparency requirements around valuation practices, fund-level leverage, and NDFI lending standards throughout the remainder of 2026.

Key Market Insights: 5 Actionable Takeaways

1. Spreads Have Re-Priced, and May Widen Further in Tech.
   In secondary markets, average B-rated loan spreads remain about 67 basis points wider than year-end levels. Technology and software credits are the epicentre of widening; lenders are demanding higher risk premiums on AI-exposed borrowers with uncertain enterprise value floors. Operators in these sectors should lock in financing structures before further repricing.
2. FCCR and Cash Flow Discipline Are Now Table Stakes. With the Fed’s April 2026 SLOOS confirming tighter NDFI lending standards (including higher premiums on riskier loans, stricter loan covenants, shorter maturities, stricter collateralization, and lower maximum credit lines) lenders are reverting to fundamental cash flow analysis. Borrowers with clean FCCR metrics above 1.2x and limited EBITDA add-backs will command materially better terms.
3. Infrastructure and Asset-Based Finance Are the Structural Winners.
   In the long term, asset-based finance is expected to challenge, or even overtake, the direct lending market, as banks continue to de-risk their balance sheets and private credit managers look to fill the gap. AI data centre financing, utilities capex, and renewable energy projects represent the most competitively priced segments for borrowers with hard-asset collateral.
4. The Distressed Ratio Is a Leading Indicator to Watch. At 8.89% in February 2026, the highest since the rate-hiking cycle began, the distressed ratio signals elevated future default risk even as headline default rates remain benign. While the headline default rate in private credit has remained below 2% for several years, once selective defaults and liability management exercises are taken into account, the “true” default rate approaches 5%. Investors should stress-test portfolios for 2021-vintage loan maturities approaching in 2027–2028.
5. Manager Selection Is Now the Primary Return Driver.
   In 2026, private credit firms that relied on broad market beta are struggling, while those with deep sector expertise and rigorous underwriting standards are thriving. Institutional allocators should prioritise managers with demonstrable multi-cycle experience, strong covenant packages, and limited software/office exposure. 81% of LPs in Preqin’s November 2025 survey plan to hold or increase their commitment to private credit throughout 2026, but the dispersion between top- and bottom-quartile managers is now at its widest point in the cycle.