In June, a healthcare software company announced an amend-and-extend transaction to push its previously agreed 2027 loan maturity further into the future – the first leveraged loan software issuer to do so this year. The transaction is unlikely to prove idiosyncratic and may instead mark a broader shift: Financial distress is likely to rise in direct lending and leveraged loans, even if the business cycle remains resilient.
This kind of distress is usually cyclical, surfacing when earnings weaken and financial conditions tighten. As discussed in PIMCO’s Secular Outlook, “Rupture and Resilience,” the emergence of credit market stress alongside stable growth and a resilient economic environment points to internal pressures rather than macro fundamentals.
Divergent paths in leveraged finance markets: Loan markets under strain
Three forces help explain the stresses in loan markets amid a more broadly benign macro backdrop:
- Higher rates continue to flow through unevenly across capital structures. The roughly 500 basis points (bps) of Federal Reserve rate tightening delivered between March 2022 and July 2023 has weighed heavily on direct lending and leveraged loans, where floating-rate exposure has driven a sharp increase in interest burdens. That has eroded interest coverage even without a growth slowdown. By contrast, high yield issuers – which are predominantly fixed-rate – have been partially insulated, delaying the transmission of tighter financial conditions.
- Direct lending is dealing with a growth hangover. The post-COVID fundraising cycle left a massive pool of committed capital to be deployed into a constrained opportunity set (see Figure 1). Excess capital chasing limited deals predictably weakened underwriting: looser covenants, aggressive EBITDA (earnings before interest, taxes, depreciation, and amortization) add-backs, permissive documentation, deferred coupons, larger deal sizes, and greater portfolio overlap across managers. In short, competition eroded many of the protections meant to compensate for leverage and illiquidity.
Figure 1: The massive post-COVID pool of committed capital had to be deployed into a limited number of deals
- Software will likely amplify these vulnerabilities. Sponsor capital in direct lending and broadly syndicated loans has been heavily concentrated in the software sector for understandable reasons: recurring revenue, high margins, and predictable cash flows that supported elevated leverage and valuation multiples. But AI disruption has started to challenge the math behind many software leveraged buyouts (LBOs), raising questions about pricing power, customer retention, and margin durability. Software has therefore become not only the largest sector in both leveraged loans and direct lending (according to PitchBook), but also a key transmission channel for stress.
Relative strength and stability in high yield bonds
If the macro cycle remains intact, the important distinction is between markets where excess capital has weakened underwriting and those where fundamentals have improved. In our view, the high yield (HY) bond market stands out: It looks stronger than its own history, stronger than leveraged loans and direct lending, and less exposed to the supply-demand imbalances that have built up elsewhere in leveraged finance.
That relative strength is visible across several dimensions. The HY market has remained broadly stable in size since 2016, while leveraged loans have grown by roughly 70% and direct lending has expanded severalfold, reflecting sustained inflows into private credit (see Figure 2).
Figure 2: In contrast to direct lending and leveraged loans, the HY bond market has remained broadly stable in size since 2016
Overall HY credit quality has also improved: As shown in Figure 3, the share of BB rated bonds has risen to a record 54%, up from 30% in 2010, while the BB share in loans has fallen to 28%, down from a peak of 45% in the wake of the global financial crisis (GFC). This partly reflects issuer composition as well as the growth of secured issuance in the bond market, which now approaches 40% of the HY universe (as represented by the Bloomberg U.S. Corporate High Yield Index).
Figure 3: The BB market share is at post-GFC highs in HY bonds and post-GFC lows in leveraged loans
Average duration in HY markets has also declined, driven by post-2022 repricing and a shift toward shorter maturities. This helps reduce sensitivity to rate volatility and lowers overall risk (see Figure 4).
Figure 4: The average duration of the U.S. HY market has declined in recent years
BB CLOs: Marks don’t need downgrades to hurt
The valuation reset that swept through software earlier this year remains largely unchanged, suggesting investors are still in “show me” mode and want evidence that AI will expand the industry profit pool rather than reshuffle it.
So far, the broader leveraged loan market has contained the damage despite software’s meaningful index weight. But the vulnerability lies beneath the surface. Much of the software loan universe is rated B−, leaving it exposed to downgrades if operating performance surprises materially to the downside. A migration into CCC territory would matter not only for software loans, but also for the broader collateralized loan obligation (CLO) ecosystem, where rating constraints could amplify dispersion.
The most widely watched metric – the share of CCC rated loans – remains below the typical 7% threshold in most deals, though it is close for deals nearing the end of their reinvestment periods (see Figure 5).
Figure 5: In the median CLO, CCC rated loans remain below the typical 7% threshold
Within the CLO market, market value overcollateralization (MVOC), which measures the market value of the collateral pool relative to the par amount of a given tranche plus all tranches senior to it, is also flashing yellow for deals nearing the end of their reinvestment periods (see Figure 6).
Figure 6: MVOC cushions are lower for deals nearing the end of their reinvestment periods
This matters because once collateral values no longer fully cover liabilities higher up the capital structure, the system becomes more sensitive to further price declines. As reinvestment periods expire, managers also lose flexibility to rotate out of weakening credits.
A wave of software downgrades could therefore create pressure beyond the sector itself – not necessarily through realized defaults, but through weaker marks and reduced structural protection.
At the index level, this supports a continued preference for HY bonds over leveraged loans. It also means relative value between the two markets should not be framed simply as a carry-versus-duration trade-off. Duration can be hedged; structural credit deterioration is harder to offset.
Michael Puempel and Gabriel Cazaubieilh contributed to this report.
