The Twilight of Liquidity: Signs of the Turning Credit Cycle
To the casual observer, the private credit markets in 2025 appeared remarkably benign. Private default rates hover near historic lows of 1.84%, and credit spreads, the premium investors demand for risk, have compressed to levels that typically signal a booming economy. Yet, beneath this veil of stability, the tectonic plates of the credit cycle are shifting. A growing chorus of regulators, including Bank of England Governor, Andrew Bailey, and seasoned investors like Howard Marks are warning that the "golden age" of private credit is facing its first true systemic test.
For students of financial cycles, the current environment offers a textbook example of the transition from the "Expansion" phase to the "Downturn" phase. However, unlike previous cycles where distress was immediate and visible, the 2025 downturn is characterized by opacity and "shadow" distress. This article explores the structural anomalies, hidden risks, and "cockroaches" that suggest the credit cycle has turned, even if the headline numbers have not.
The Great Spread Paradox
In a classical credit downturn, risk premiums widen. As companies struggle to pay debts, lenders demand higher interest rates to compensate for the increased probability of default. Today, we are witnessing the opposite: a "Spread Compression Anomaly." Despite a base rate environment where the Secured Overnight Financing Rate (SOFR) hovers near 4%, spreads in the direct lending market have tightened, eroding the "illiquidity premium" investors historically received for locking up their capital.
This anomaly is driven by supply, not safety. Private credit funds are sitting on record levels of "dry powder" (uninvested capital) that must be deployed. This wall of money creates fierce competition for deals, allowing borrowers to dictate terms and compressing spreads even as their underlying fundamentals deteriorate. This is a critical lesson: Price is not always a proxy for risk; in liquidity-flush markets, it is often just a proxy for the supply of capital.
The "Shadow Default" Rate
If the market price of credit is masking risk, where can we find the truth? The answer lies in the granular mechanics of borrower cash flow. Two metrics reveal the deepening issue in the middle market: Interest Coverage Ratios (ICR) and Payment-In-Kind (PIK) usage.
The ICR measures a company's ability to pay interest from its operating earnings. In 2025, approximately 27% of private credit borrowers have an ICR below 1.0x. This means more than one in four companies are technically insolvent on a cash-flow basis; they cannot service their debt without burning cash reserves or receiving new equity injections.
To avoid formal default, many of these "zombie" companies have turned to PIK interest. PIK allows a borrower to pay interest by issuing more debt rather than paying cash. In the second quarter of 2025, PIK income across Business Development Company (BDC) portfolios remained elevated at 12.8%. While this keeps the "headline" default rate low, it creates a "shadow default rate" that rating agencies like Fitch estimate could be as high as 5.7% if these support mechanisms were removed.
Cockroaches in the Coal Mine
Howard Marks of Oaktree Capital famously applies the "cockroach theory" to credit markets: "If you see one cockroach in your kitchen, there are likely hundreds in the walls". In late 2024 and 2025, the market spotted two massive cockroaches: First Brands Group and Tricolor Auto Group.
First Brands Group: This auto parts conglomerate collapsed into bankruptcy with over $12 billion in debt. The shock was not just the failure, but the opacity that enabled it. Post-mortem analysis revealed that the company had accumulated roughly $2.3 billion in off-balance-sheet obligations and factoring arrangements that lenders had seemingly missed.
Tricolor Auto Group: A subprime auto lender, Tricolor failed amid allegations of "double-pledging" collateral, using the same pool of car loans to secure credit lines from multiple different banks.
These failures are not merely idiosyncratic bad apples; they are symptoms of a late-cycle environment where the "reach for yield" leads to sloppy due diligence. They validate Governor Bailey's warning that private credit's lack of transparency can hide leverage that only becomes visible when the tide goes out.
The Illusion of Stability: "Volatility Laundering"
The reason this hasn’t caused a broader panic could be attributed to what quantitative researcher Cliff Asness calls "volatility laundering". Unlike public bank loans (syndicated loans) which trade daily and are marked-to-market, private credit assets are valued using models. This allows managers to smooth out valuations, reporting stable returns even when the underlying economic value of the loans is volatile.
While this creates a soothing experience for investors, it delays the "Repair" phase of the credit cycle. By refusing to mark assets down to their true clearing price, the market delays the necessary restructuring of bad balance sheets.
Conclusion: The Inevitability of Repair
The 2025 credit landscape offered a profound case study in the difference between liquidity and solvency. The market remains liquid, funds are raising capital and banks are lending, but a significant cohort of borrowers is insolvent, sustained only by financial engineering like PIK and covenant-lite structures.
As the "higher for longer" rate environment persists, the gap between the calm surface and the turbulent reality must eventually close. For students and practitioners alike, the lesson is clear: in the late stages of a credit cycle, look past the spread and focus on the documentation, the cash flow, and the meltdowns.