Private credit stress test as higher rates squeeze borrowers
Long-term high interest rates were once heralded as an attractive driver of returns for private loan investors, but industry professionals say tighter monetary policy has become the industry’s next big stress point.
Global central banks are grappling with renewed inflationary pressures following the energy crunch caused by the Middle East war, raising the possibility of further interest rate hikes.
This is a problem for private loans, where the debt often has fluctuating interest; This means debt servicing costs are likely to remain higher for underlying borrowers across many portfolios, while lenders are forced to distinguish between temporary flexibility and deeper credit stress.
This comes at a time when the $2 trillion private sector is already grappling with ongoing repayment pressures at retail-focused business development firms, fears that the AI-driven ‘SaaSpocalypse’ will upend software-heavy portfolios, and individual corporate implosion.
Anant Kumar, managing director, global investment strategist, head of US credit research and portfolio manager at Benefit Street Partners, said the current private credit lending environment is built on the assumption that the rise in interest rates in 2022 and 2023 is a peak that will quickly decline.
“Three years later, borrowers are still paying coupons near the peak,” Kumar said. “In fact, the market is now pricing in increases, not cuts. No one has committed to this.”
Special credit pressure points
Annual core US inflation, which excludes food and energy prices, jumped to 2.9% year-on-year in May, its highest level since September 2025, and is expected to remain at that level when the June figure is released on Tuesday, according to consensus forecasts.
Kumar said higher base rates generally help in the short term as yields rise. But if interest rates remain high for a long period of time, more marginal borrowers could be squeezed by interest servicing costs.
“If rates rise from here, many leveraged companies will not be able to survive on their current capital structures. This does not mean businesses are dead. This means restructuring,” he told CNBC via email.
Pressure on borrowers currently comes in the form of maturity extensions, payment-in-kind (PIK) interest, sponsor checks and contract relief — “usually in that order,” Kumar said.
“One change is good; it’s just private loans working as designed. But the fourth change of the same name is a delay, not a bridge to recovery,” he explained.
Sunaina Sinha Haldea, global head of private equity advisory at Raymond James, said higher interest rates do not uniformly distort private credit, but they eliminate the margin of error.
“The problem is not variable-rate loans per se. The problem is variable-rate leverage on businesses that are committed to a different interest rate regime,” he said. “PIK, covenant relief and maturity extensions can be useful tools when they buy time for a real recovery. They become risky when used to maintain par ratings and delay recognition of loss.”
PIK agreements are an increasingly closely watched indicator of private credit stress. These arrangements, which allow borrowers to defer cash interest payments by adding them to the loan principal, often for a fee, can often signal liquidity stress and increased default risk.
“This is one of the most watched figures in the market,” Kumar said, citing data from Lincoln International showing that more than 10% of direct lending loans now have a PIK component. This rate was 7% in late 2022.
“It’s okay for PIK to be pre-negotiated for a growing company. Conversion of PIK to a mid-life cash-out loan is indicative of this… We treat rising PIK as a smoke alarm, but not a reason to push the panic button.”
Lenders are becoming more selective
Looking ahead, the high interest rate environment is likely to create a more selective environment for private credit, said Nicole Reid, private market solutions research analyst at Aberdeen Investments.
“The impact on borrowers is increasingly diverse, with stronger businesses continuing to perform well while weaker loans face greater refinancing pressure,” Reid said. he said. “Defensive, non-cyclical sectors with good cash flow visibility continue to be better positioned to absorb a higher interest rate environment over the longer term.”
As stress becomes more visible in the form of extensions, PIK agreements and other liability management measures that provide short-term cash flow relief, Reid said there is increased scrutiny of sectors where leverage and valuations have been stretched during the low-interest period. This is especially true in parts of the software market, where Reid said lenders are responding with wider spreads, tighter underwriting standards and a greater focus on cash flow flexibility.
Kumar added that companies most at risk are those that fall under fixed charge, have thin margins, small buffers and limited ability to absorb prolonged periods of high interest rates.
The squeeze is sharpest for companies with weak pricing power, where operating costs and financing costs are rising but revenues are not keeping pace. Kumar added that real estate-related borrowers are particularly sensitive to interest rates, while consumer businesses with exposure to low-income customers face additional pressure.
“This is cutting across industries… It really depends on the situation. You need to guarantee margins, pricing power and coverage.”
Kumar said size alone is not a reliable guide; Larger companies may have better margins, but they generally carry more leverage and are therefore more sensitive to rates. Small companies, on the contrary, may be more agile.
“It’s a complex interaction. I insure the company, not the size range,” he added.
“This is a pressure test, not a crisis. Longer duration separates managers who take on a downside from managers who take on a refinancing that never comes. The next 18 months are a story about distribution among lenders, not losses across the asset class.”
