Morgan Stanley says AI disruption of software will send private credit defaults surging

• Morgan Stanley says defaults in private credit could jump toward COVID-era highs.
• The bank sees loan defaults being driven by AI's disruptive effects on the software sector.
• Software accounts for around 20% the direct lending market, Morgan Stanley estimated.

The specter of AI disruption of the software sector could send defaults in private credit soaring to their highest level since the pandemic, Morgan Stanley said.

In a note on Monday, a team of strategists at the bank said they foresee a big surge of defaults in direct lending. That corner of the space accounts for more than half of all assets under management in the private credit universe, according to a previous Morgan Stanley analysis.

Defaults in the direct lending space could soar to 8%, the strategists estimated, nearing the peak default rate seen during the pandemic. The trend will largely be driven by the disruptive effects of AI on software companies, they added.

"In our view, AI disruption will be a meaningful catalyst to drive defaults in direct lending," the bank said. "Despite moderating defaults and benign ratings trend, credit fundamentals of software loans are challenged with the highest leverage and the lowest coverage ratios across major sectors."

Software has been a key focal point for investors watching the private credit space. Software loans account for around 40% of all private equity-backed loans outstanding, according to one Bloomberg analysis, and software exposure in the direct lending hovers around 20%, Morgan Stanley said, basing its estimates on holdings data of various private debt vehicles.

The sector has been rattled by fears that AI could disrupt the business models of many software-as-a-service companies. The iShares Expanded Tech-Software Sector ETF is down 17% from levels at the start of the year, reflecting a steep sell-off in late January as investors panicked about a potential "software apocalypse."

Private loans made out to the software sector also look to be approaching a "maturity wall," Morgan Stanley said. Around 11% of loans in the space are set to mature by the end of next year, followed by another 20% by the end of 2028, the bank estimated.

"We expect defaults to be concentrated within software and AI-adjacent sectors, unlike the COVID cycle where defaults peaked across multiple sectors simultaneously," the strategists wrote, adding that they expected spillover to the broader private credit market to be limited, despite "significant" risks.

Concerns have been swirling around the health of the private credit sector since subprime auto lender TriColor Holdings and auto parts company First Brands went bankrupt late last year. More recently, private credit funds have been hit with a wave of redemption requests, leading some market pros to warn about the risk of a credit event that could spread to other areas of the market.