Private credit has been Wall Street's hottest asset class, attracting trillions of dollars from pension funds, endowments, and wealthy individuals seeking yields that traditional fixed income can no longer provide. The market has tripled in size since 2015, and projections suggest it will reach $5 trillion by decade's end. But as money floods in, warning signs are emerging that the quality of underlying loans is deteriorating—potentially setting up investors for painful losses when the next recession arrives.

Morningstar DBRS, one of the leading rating agencies for private credit, has issued a negative outlook for borrower credit quality heading into 2026. The assessment represents a sobering counterpoint to the industry's relentless growth narrative.

The Growth That Got Us Here

Private credit—loans made by non-bank lenders to mid-sized companies—has exploded for understandable reasons. After the 2008 financial crisis, regulations limited banks' ability to make risky corporate loans. Private credit funds stepped into the void, offering flexible financing to companies that couldn't access traditional bank lending or public bond markets.

The numbers tell the story of extraordinary growth:

  • 2015: Approximately $500 billion in assets under management
  • 2020: $2 trillion
  • 2025 (present): $3 trillion
  • 2029 (projected): $5 trillion

Investors have been rewarded for taking the plunge. Private credit has delivered yields of 10-12% annually—far exceeding what investment-grade bonds or even high-yield corporate bonds offer. The asset class has become a core holding for institutional portfolios worldwide.

What Morningstar DBRS Found

Morningstar DBRS's negative outlook stems from troubling trends in the underlying loan portfolios that private credit funds hold. Their analysis identified several concerning patterns:

Margin compression: A growing number of borrowers are experiencing declining profit margins as input costs rise and pricing power wanes. Weaker margins mean less cash flow to service debt payments.

Leverage increases: Many private credit borrowers have taken on additional debt since their original loans were issued. This "leverage creep" means borrowers are more fragile than their initial credit profiles suggested.

Payment-in-kind (PIK) usage: More borrowers are electing to pay interest in the form of additional debt rather than cash—a red flag that suggests cash flow stress.

Covenant erosion: As competition among lenders has intensified, covenant protections that would typically alert lenders to trouble have been weakened or eliminated.

"Fundamental operating results show an increase in borrowers experiencing margin compression, and leverage has also increased materially for many borrowers," Morningstar DBRS noted in its outlook.

The Fee Squeeze Adds Pressure

Simultaneously, private credit managers face growing pressure on their own economics. As the market has grown more competitive and attracted large institutional investors with bargaining power, management fees have come under pressure.

According to Alternative Credit Investor, fee compression is being driven by:

  • Heightened competition: More managers are chasing the same deals, giving borrowers and investors leverage to demand better terms.
  • "Big ticket" LP influence: Large pension funds and sovereign wealth funds can negotiate fee discounts unavailable to smaller investors.
  • Performance pressure: With fees declining, managers may feel pressure to take more risk to maintain returns.

This dynamic creates a troubling incentive structure: just as credit quality is deteriorating, managers face pressure to maintain yields—potentially by making riskier loans.

The AI Infrastructure Wild Card

One factor complicating the private credit outlook is the massive capital flowing to AI infrastructure projects. Data centers, power generation facilities, and cooling systems require trillions of dollars in investment—and much of that financing is coming from private credit.

J.P. Morgan's 2026 Global Alternatives Outlook highlights this convergence:

"AI adds urgency to infrastructure investments: data centers and power systems face surging demand, requiring trillions of dollars in investment for capacity, cooling, and grid resilience. This convergence of physical and digital infrastructure creates a defining investment theme spanning private equity, infrastructure, real estate, and private credit."

While AI-related lending could provide attractive returns, it also represents a concentration of risk. If the AI boom disappoints—or if power generation projects face delays—private credit portfolios with heavy AI exposure could suffer.

What a Downturn Would Reveal

Private credit has grown to its current size during an extended period of economic expansion. The asset class has never been tested by a significant recession.

Several characteristics make private credit potentially vulnerable during downturns:

  • Illiquidity: Unlike public bonds, private credit holdings cannot be easily sold. Investors seeking to exit during a crisis may find no buyers.
  • Valuation opacity: Private credit is not marked to market daily. During benign periods, this smooths returns; during crises, it can mask losses until they become undeniable.
  • Leverage on leverage: Many private credit funds use leverage to boost returns. Leveraged exposure to leveraged borrowers amplifies both gains and losses.
  • Covenant-lite structures: Weak covenants mean lenders may not discover borrower distress until it's too late to intervene effectively.

The Institutional View

Despite the warning signs, major institutional investors remain bullish on private credit. Bank of America recently signaled "growing optimism for the alternatives space in 2026, with private credit, fixed income e-trading, and crypto as key to driving investor interest."

J.P. Morgan's alternatives platform—spanning $600 billion across asset classes—continues to expand private credit allocations. The firm's 2026 outlook describes private markets as "a structural mainstay of global finance."

This continued institutional support suggests that even if credit quality is deteriorating, the money spigot isn't closing. Investors are betting that the yield premium justifies the emerging risks.

What Investors Should Consider

For individual investors with private credit exposure—often through interval funds, business development companies, or alternative investment platforms—several considerations apply:

  • Understand your exposure: Know what portion of your portfolio is in illiquid credit investments and whether you can tolerate extended periods without access to that capital.
  • Assess manager quality: Not all private credit managers are equal. Those with conservative underwriting standards and strong workout capabilities may navigate a downturn better than aggressive yield-chasers.
  • Consider the cycle: Private credit performs best during economic expansion. With recession risks elevated, the risk/reward may be less favorable than in recent years.
  • Watch for PIK increases: If your private credit fund reports increasing payment-in-kind interest, it may signal stress in the underlying portfolio.

The Bottom Line

Private credit's surge from $2 trillion to $3 trillion—with $5 trillion projected—represents one of the most significant shifts in financial markets of the past decade. But Morningstar DBRS's negative credit quality outlook should give investors pause. The combination of deteriorating borrower fundamentals, increasing leverage, and fee pressure on managers creates a potentially fragile structure. Private credit may well continue delivering attractive returns. But the next recession will reveal whether those returns adequately compensated investors for risks they're only beginning to understand.