Morningstar DBRS is reporting a continued decline in private credit quality so far this year, with the proportion of downgrades hitting a new monthly high in February.
In February, downgrades outpaced upgrades by a factor of 3.3 to 1, up from a ratio of 2.4 to 1 a year earlier. That shift is part of a broader trend that has prompted the agency to adopt a negative outlook for 2026, citing margin compression across multiple sectors and elevated debt levels, Michael Dimler, senior vice president for private credit ratings, said in an interview on Monday.
Morningstar DBRS currently assigns private credit ratings to roughly 450 middle market borrowers across North America and Europe. Those rated companies have average revenues of about $250 million.
As private credit has expanded, participants and market observers are wrestling with how to gauge default and liquidity risks for lenders, including large private equity firms that act as financiers. Private credit lenders generally do not publish the same depth of data as public markets or bank balance sheets, making it harder for outside investors to pinpoint where stress may concentrate. In contrast, loans held in public markets or on bank books typically disclose more information, which supports more detailed analysis of potential defaults and risk exposures.
Portfolio mix and default trends
With downgrades rising, Morningstar DBRS says the overall credit quality of its rated portfolio has weakened. The share of companies viewed as higher-quality credits - those rated in the B category and above - declined from 41% to 39% over the past 12 months. At the same time, companies in the most speculative bands, rated between CCC and C, now constitute 16% of the rated universe, up from 12% a year ago.
Defaults have also increased, reaching 4% in February compared with 3.2% in the prior year.
Technology and AI considerations
Morningstar DBRS is monitoring the potential disruption that artificial intelligence could pose to software companies. To date, Dimler said, AI has not produced a substantial shift in ratings among the firms the agency covers. He drew a parallel to the earlier industry transition from physical software distribution to cloud-delivered, subscription business models.
"Software developers 92 results were affected for some years, but companies that invested were able to complete the transition and improve earnings later," Dimler said.
Borrowing costs are already on the rise, and some software companies are choosing to put off debt transactions amid higher funding expenses. In assessing which software businesses might be most exposed to disruption, Dimler noted the importance of customer relationships and the expense for clients to switch away from incumbent products.
Overall, Morningstar DBRS 92 findings underscore a growing set of headwinds for private credit: a larger share of speculative-grade issuers in its rated pool, climbing defaults, and an economic backdrop that the agency expects will continue to exert pressure on margins and leverage into 2026.