Leveraged Finance Spotlight: Credit Risk Heavily Dependent on Economic Stability in 2025

Welcome to the inaugural issue of Leveraged Finance Spotlight. The primary focus of this publication is to chronicle credit trends across private credit, credit estimates, and structured credit. We will also highlight content relevant to leveraged finance from other Morningstar, Inc. platforms. In this edition of Leveraged Finance Spotlight, we feature the following:

Pricing in Direct Lending Has Been Slow to Move Amid Declining Interest Rates

Michael Dimler, Senior Vice President, Private Credit, reports that "data from our surveillance portfolio of privately rated middle market issuers and from our database of credit estimates suggest that repricing of existing direct lending loan spreads across our rated portfolio is lagging the broadly syndicated loan (BSL) collateralized loan obligation (CLO) market. However, we note a clear decline in average loan spreads between nearer-dated maturities and longer-dated ones, indicating that new loan underwriting is slowly pricing in tighter spreads."

Private Credit Outlook

According to Michael Dimler, Senior Vice President, Private Credit: "We expect more-vulnerable, low-rated private credit borrowers to remain stuck in the mud in 2025, continuing to contend with sluggish or declining sales, weak margin trends, and still-elevated borrowing costs. Meanwhile, fundamentals are likely to continue to strengthen across a broader set of higher-rated middle-market firms." Mr. Dimler also added: "Given these diverging performance trends, we believe the pace of downgrades across our rated portfolio could slow by late 2025, though already-weakened issuers are likely to drive further default events in the near-term."

U.S. CLO 2025 Outlook

Joseph Priolo, Senior Vice President, U.S. Structured Credit, predicts "borrower performance in 2025 will remain supported by lower interest rates, deregulation, and higher capital spending needs." However, he also notes that "increasing tail risk could bring renewed pressure to bear on borrowers through adverse impacts from inflation and interest rate conditions or geopolitical events."

European BSL/SME CLO Outlook

"Our stable outlook across structured credit markets is based on improving macroeconomic indicators such as inflation and interest rates," said Carlos Silva, European Structured Credit team lead. "However, minimal forecast economic growth across the largest European economies remains a concern while geopolitical uncertainty remains a top consideration and could derail our stable forecast."

BDC 2025 Outlook

"Morningstar DBRS' outlook for business development companies (BDCs) is biased toward the upside in 2025. While we expect a dispersion of operating results to continue through 2025, BDCs will have to navigate lower base rates coupled with potential investment portfolio credit deterioration which may be mitigated by supportive domestic protectionist policies and a robust origination market," said Watson Tanlamai, CFA, Vice President, NA Financial Institutions Ratings.

Catch up on these topics and more thought leadership from across Morningstar and around the globe in this month's edition.