KBRA Financial Intelligence

3 Things in Credit: Slowdown, Leveraged Loan Surge, and Default Forecasts

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Welcome market participants, to another 3 Things in Credit. I’m Van Hesser, Chief Strategist at KBRA. Each week we bring you 3 Things impacting credit markets that we think you should know about.

Stocks in the S&P 500 are now valued by investors at more than 3.3x their sales, an all-time high. We’ve talked recently about growth catalysts that underpin risk markets, and we’ve certainly included artificial intelligence in that group. Tom Joyce and team over at MUFG relate AI capex forecasts from McKinsey over the next five years to the size of various global economies. The midpoint of McKinsey’s scenarios, $6.6 trillion, is larger than the GDP of every economy except two: the U.S. and China. Yes, the AI spend figure is over five years and we are comparing to one year GDP of individual countries, but it is a big number that no one was thinking about five years ago. Now, on to the second-order effects. What does this do to productivity? To employment? To particular industries? It’s going to be a bumpy ride.

This week, our 3 Things are:

1. Anatomy of slowdown. Risk markets are flying—how do we get to slowdown?

2. Leveraged loan surge. The market has rebounded from April’s freeze with a vengeance. Is it overheating?

3. KBRA’s default forecast. We’ll check in with Eric Rosenthal for his latest.

Alright, let’s dig a bit deeper.

Anatomy of slowdown.

Last week we highlighted catalysts driving U.S. economic growth: broad acceptance of AI as a strategic imperative (and the capex that goes with it), reduced policy uncertainty, the prospects of deregulation, stimulus courtesy of One Big Beautiful Bill, the likelihood that the Fed will finally resume cutting rates. Add to the list wealth effect from stocks that have more than recovered ground lost in April. It all adds up to a powerful growth impulse. Even the IMF capitulated this week by raising its 2025 growth estimates from its previous forecast back in April. For the world, the IMF has increased its growth estimate from 2.8% to 3%, for the U.S. from 1.8% to 1.9%, the eurozone from 0.8% to 1.0%, and China from 4% to 4.8%. A clean sweep. Skies have cleared.

So, how do we get to below-potential growth for the U.S.? In a nutshell, normalization plus some uncertainty. Let’s walk through this.

Normalization is life fully post-COVID era stimulus. What was abnormal? Material excess savings across the middle to lower wealth households. Super easy credit conditions for both businesses and consumers. Unusually tight labor markets driving higher-than-normal consumer wage gains. Elevated equity and residential real estate valuations. It all adds up to unsustainable economic growth.

“Normal” means excess savings have run off, labor markets have loosened, and interest rates have snapped back into a historically typical range. Credit has tightened to both consumers and businesses. The one piece yet to correct is equity and home valuations. Stocks selling off in April gave us a sense as to the importance of wealth effect, especially considering that the top 10% of earners—those that have significant investment and real estate holdings—account for 50% of spending.

Now, layer on top of normalization: uncertainty. Yes, some uncertainty has lifted with better definition of the administration’s trade policy and its negotiating tactics vis-a-vis trading partners, as well as passage of the Big Beautiful Bill. But much uncertainty remains:

• What will the bite of tariffs look like once fully implemented?

• How will the markets react to rising debt and deficits?

• How will weak soft data—surveys—transmit into hard data?

• How will higher-than-normal consumer and commercial loan delinquencies affect credit availability?

• And on the growth-positive side, how much stimulus will come out of the Big Beautiful Bill, and how much growth will come from deregulation?

Net net, we see uncertainty still weighing on economic activity. We’re seeing interest-sensitive sectors continue to slow. Tightened credit conditions are leaning on sentiment, which is taking the wind out of the sails of real personal consumption, which, over the past six months has flattened. Housing activity is weakening further. Construction spending growth has turned negative.

Slowdown is showing up in the numbers. The so-called “core GDP” number, Final Sales to Private Domestic Purchasers, came in at a weak 1.2% for the first half of 2025, the slowest rate since the second half of inflation-battered 2022. The post-GFC average? 3.1%. Slowdown is happening.

Now throw into the mix the bite of tariffs. The Treasury Secretary has pointed to the tariff revenue expectations: “Well more than $300 billion” in 2025. While the debate will rage as to where that revenue comes from, importers or consumers, we can all agree that it has to come from somewhere. That ends up as reduced purchasing power. That’s another headwind.

To be clear, we are not forecasting recession as a base case. Our one-year recession probability stands at 30%. We are, however, forecasting modest stagflation over the next 12 months, with below-potential growth and slightly higher-than-desired inflation. It’s an environment that is not all that bad for credit, especially higher quality credit.

Alright, on to our second Thing—Leveraged loan surge.

“I haven’t seen a market quite like this post the great financial crisis.” So says Jon Poglitsch of Sycamore Tree Capital Partners, referring to the ferocious demand for yield-y paper in leveraged finance. That’s quite a turnaround from Q1, when much of the market had shut amid uncertainty related to the administration’s evolving trade policy. Turns out July will be a monthly record for leveraged loan launches— $208 billion, according to Bloomberg.

Some of that supply is obviously pent-up borrower demand from that noisy first quarter. And we know what’s changed—better visibility into how the administration intends to execute its tariff plan. But does this yield grab in leveraged finance make sense given our first Thing, slowdown?

If we look at the trimmed mean fundamental data for Bloomberg’s high-yield universe, we see that net debt to EBITDA has remained relatively constant from pre-pandemic: 3.8% Q4 2019 through today at 3.7%. Somewhat surprisingly, so has interest coverage—2.6x in 2019, 2.7x today—despite the rate rise. Narrowing our look to single-B credits, net debt to EBITDA has gone from 4.2% in 2019 to 4.1% today while interest coverage has gone from 2.2x to 2.0x today.

So, fundamentals have remained relatively constant. What about yields? The S&P UBS Leveraged Loan Index Yield to Maturity has declined steadily since its recent peak at 10.6% in Q4 2022, when consensus one-year recession probabilities were running at around 60%. Today, with recession probability at 35%, yields have fallen down to 8.1%, still above the 7.5% 20-year average. Facing our modest stagflation forecast of below-potential growth and slightly above-target inflation, we see reasonable value atop the capital stack in leveraged loans. Just not as much as was the case in 2023-24.

Alright, on to our third Thing—KBRA’s default rate forecast.

I am joined once again by Eric Rosenthal, who tracks defaults for KBRA across broadly syndicated loans, high-yield bonds, and private credit. Eric generates our default forecasts as part of his work with KBRA DLD, our direct lending news and analytical platform. [Note: KBRA DLD is division of KBRA Analytics.]

Eric, welcome back to the podcast.

Eric: Thanks, Van, and great to be back.

Van: Your 2025 forecast called for broadly syndicated loans to finish at 3.75% and for high yield at 2.25% on a volume basis. Have there been any changes to your forecast?

Eric: Our forecasts remain unchanged even amid the uncertainties posed by tariffs and other macroeconomic issues.

For broadly syndicated loans, we anticipated $58 billion of default volume. Currently, we stand at $37 billion. Although this is slightly above the projected pace, the total for the Default Radar Red list—which highlights the most concerning credits—has declined significantly. The total is down more than 40% since January, marking the lowest level recorded since we implemented this tracking system in 2023. This suggests default volume should slow down during the latter portion of the year.

While it’s more likely the default amount ends 2025 above our forecast rather than below it, the expanding universe size (approaching $1.6 trillion) continues to offset any potential rate increase.

Van: Got it—how about for high yield and the pace seen thus far?

Eric: Right, it's the opposite story for high yield. We anticipated $32 billion of volume for 2025 but just $11 billion has occurred thus far. An additional $3 billion is expected in August, through three distressed debt exchanges, highlighted by Saks Global. The big question remains: What will happen to Dish? Does a filing occur, a somewhat smaller distress exchange, or can the company somehow make it through 2025 without defaulting?

If a bankruptcy filing or large distressed debt exchange is avoided, a default rate below 2% for the second consecutive year becomes highly likely.

Van: Let’s turn our attention to private credit. What are your thoughts on the default rate?

Eric: We forecast a 1.5% rate by volume, a decline from the 1.8% observed in 2024. This slight decrease is largely due to the absence of a major default comparable to Pluralsight’s in 2024. While Khoros defaulted in May and 48forty Solutions has drawn attention amid reports of a potential restructuring, the vast majority of expected 2025 defaults likely involve smaller-sized companies. As a result, the overall volume impact remains lower despite the anticipated uptick in the number of defaults.

Note the Direct Lending Default Radar has climbed to 207 issuers, from 183 at the end of 2024. While we don’t expect all these names to default, the rising number could pose a challenge to 2026 rates. Sort of like your Phillies trying to challenge my Mets for the division.

Van: You had to throw that dig in there didn’t you? Let’s hope they swap positions when the podcast posts. Anyway, if default rates are relatively low, what is your biggest concern for private credit in 2025?

Eric: Implied recovery rates are my biggest worry. This level stands at 51%, based on a sample of 22 issuers year-to-date, findings essentially in line with 2024 that involved a cohort double in size. We should get more restructurings once BDCs release their Q2 results; that picks up next week.

Our 2025 forecast is an even lower 48 cents. The reason for that is of the 124 Red Default Radar borrowers, the average fair value mark is 56. Typically, about 70% of the Red list population has a decline in fair value each quarter, reinforcing the view that these situations seldom improve.

Van: Understood. Finally, any new developments from your team?

Eric: Yes, regarding our quarterly European Direct Lending Default report, we are now including default rates and implied recoveries along with 2025 forecasts. While our universe of 300+ borrowers is significantly smaller than the 2,600+ in the U.S., there is enough of a sample to project a 1.25% rate and a 40% implied recovery for 2025.

Van: Great. Remind our listeners where they can find your research.

Eric: Follow KBRA DLD on LinkedIn—and to receive our defaults weekly in your inbox, or access all our reports on liquid credit and direct lending, contact Niki Masino at [email protected]

So, there you have it, 3 Things in Credit.

1. Anatomy of slowdown. The direction of travel back to normal plus policy uncertainty are weighing on growth.

2. Leveraged loan surge. As long as growth doesn’t tip into recession, leveraged loans’ yield will continue to draw demand.

3. KBRA’s default forecast. All things considered, defaults remain relatively well behaved.

As always, thanks for joining. We’ll see you next week.