Private Credit and the Asymmetry of Default Risk

Originally published in 2025. Expanded and updated in October 2026.

The attraction of private credit is easy to understand: contractual income, floating-rate exposure in many strategies, negotiated lender protections and an illiquidity premium.

The risk is equally fundamental.

A lender’s return is asymmetric.

If a borrower performs exceptionally well, the lender generally receives the agreed interest and principal. If the borrower fails, however, the lender can lose a meaningful portion of capital.

That asymmetry is why default and recovery analysis matters so much.

Default rate is only half the equation

A default does not automatically imply a total loss.

The economic impact depends on recovery: how much value lenders can ultimately realise through collateral, restructuring, refinancing or enterprise value.

A portfolio with a given default rate can therefore produce very different returns depending on recoveries.

J.P. Morgan illustrated this relationship in 2025 using a simplified private-credit return framework. At that time, it cited private-credit default rates around 2.4% at the end of Q1 2025 — far below the extreme assumptions sometimes used in stress tests.

The purpose of stressing higher defaults is not to predict that they will occur. It is to understand how quickly lender economics deteriorate if both defaults rise and recoveries weaken.

Higher rates expose weak capital structures

When base rates rise, floating-rate borrowers can face materially higher interest expense.

A company that appeared comfortably levered when debt was cheap may experience declining interest coverage even if EBITDA remains stable.

That creates several possible pressure points: lower free cash flow, covenant stress, inability to refinance at maturity, requests for amendments and eventually restructuring.

The lesson is that leverage should be assessed not only against today’s earnings, but against stressed cash generation and a realistic refinancing environment.

Underwriting versus documentation

Strong documentation cannot rescue a fundamentally weak credit, but it can materially influence outcomes when performance deteriorates.

Collateral, covenants, reporting requirements, restricted payments and control rights affect the lender’s position during a restructuring.

At the same time, competitive markets can weaken lender protections. When capital is abundant, the pressure to deploy can make structure and pricing more borrower-friendly.

This is why underwriting standards matter most precisely when an asset class feels safest.

Selectivity can become an opportunity

Periods of stress are not purely negative for lenders.

If weaker competitors retreat and financing becomes scarce, new loans can potentially be originated at wider spreads, lower leverage and stronger documentation.

The opportunity is therefore cyclical: deteriorating credit conditions can hurt existing portfolios while improving the prospective economics of new deployment.

An investment perspective

The central question in private credit is not whether defaults will rise by a particular number of basis points.

It is whether the portfolio has been built so that expected income adequately compensates for unexpected loss.

That requires looking beyond headline yield to leverage, coverage, collateral, documentation, maturity walls and recovery value.

Credit investing is ultimately an exercise in surviving the cases where the base case is wrong.