Private credit quality is weakening at the start of 2026, with downgrades significantly outpacing upgrades, according to rating agency Morningstar DBRS. The firm reported that the number of downgrades in February was 3.3 times the number of upgrades, a sharp increase from the 2.4 ratio recorded a year earlier, signaling mounting stress in the fast growing private lending market.
Morningstar DBRS currently rates around 450 middle market borrowers across North America and Europe, with average annual revenues of roughly 250 million dollars. The agency said the outlook for 2026 remains negative, citing margin compression across multiple sectors and rising debt burdens as key drivers of credit deterioration.
As private credit has expanded in recent years, institutional investors have increasingly turned to direct lending funds and private equity backed vehicles in search of higher yields. However, unlike public bond markets or bank balance sheets, private credit portfolios often lack the same level of transparency, making it more difficult for investors to assess underlying default and liquidity risks.
The rating agency noted that the overall quality of its rated portfolio has declined over the past 12 months. Companies classified as relatively safer credits, including those rated in the B category, now represent 39 percent of the portfolio, down from 41 percent a year earlier. At the same time, riskier borrowers rated between CCC and C have increased to 16 percent of the total, up from 12 percent in the prior year.
Default rates are also trending higher. Morningstar DBRS reported that defaults reached 4 percent in February, compared with 3.2 percent a year earlier. While not yet at crisis levels, the upward trajectory reflects tighter financial conditions and pressure on corporate earnings.
Rising borrowing costs have played a central role in this shift. Higher interest rates have increased debt servicing expenses for leveraged companies, particularly those operating in sectors facing slower growth or competitive disruption. Some firms have delayed refinancing or new debt issuance as a result of less favorable market conditions.
The agency is also monitoring the potential impact of artificial intelligence on software companies within the private credit universe. Although AI related disruption has not yet materially affected ratings, analysts are assessing which businesses may face longer term challenges. Companies with strong customer relationships and high switching costs are viewed as better positioned to adapt, while those with more commoditized offerings may be more vulnerable.
The evolution of private credit is closely watched by regulators and investors alike, given its growing share of corporate financing. As downgrades rise and default rates edge higher, market participants are focusing on how well private lenders manage risk in an environment marked by elevated debt levels and uneven economic growth.
