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Opinion CLOs
BSL volatility could create opportunities to deploy capital at attractive levels
by Dagmara Michalczuk
Dagmara Michalczuk
Co-chief investment officer
Tetragon Credit Partners
A liquidity crunch in private credit will hit BSL CLOs — but there may be an upside for disciplined managers
For years, the relationship between the broadly syndicated loan (BSL) and direct lending markets has been framed as a simple contest for market share among below-investment-grade borrowers and their sponsors. It made for attention grabbing headlines and neat marketing narratives.
Reality is, of course, far more complex. These markets operate within an interconnected financing ecosystem, where capital flows and risk dynamics in one segment inevitably affect the other. At times, they have been as much friends as foes. BSL investors, for instance, have benefited from direct lenders’ willingness to refinance weaker syndicated loans, effectively trimming tail risk from the BSL universe. The resulting migration of higher risk BSL names to the private credit market has drawn comparisons to the evolution of the US high yield bond market. More broadly, the so-called ‘private capital put’ has likely helped reduce BSL defaults.
Overlap among riskier borrowers
Competition between the two markets is also more limited than often portrayed. Meaningful overlap tends to occur primarily among higher risk borrowers. This reflects structural constraints, as the largest BSL investors are arbitrage CLOs that cannot absorb the same levels of credit risk, illiquidity and small-company exposure as direct lending funds. While credit quality and company size have provided a natural demarcation line between the markets, risk taking and underwriting quality patterns have filtered across it.
One indication of this is the spread compression experienced across both markets over the past few years, even as defaults remained substantial. Another sign is the migration of weaker covenants into parts of the private credit market.
The interconnections extend beyond market dynamics. The same pools of capital, including pensions, insurers and sovereign wealth funds, often underpin both ecosystems. Banks invest in both BSL and private credit CLOs, while also providing financing to private credit funds. Additionally, many asset managers operate across both markets and are exposed to performance and reputational risks spilling across their platforms.
Most importantly, all borrowers are subject to the same macroeconomic reality. Recent geopolitical tensions and the energy price shock linked to the Iran conflict have pushed inflation and stagflation risks back to the top of investors’ worry lists. At the same time, AI-driven disruption remains a persistent concern. After a period of rapid growth, the PC market may be approaching its first meaningful test: a combination of secular industry disruption and extended cyclical pressure.
This matters for the broader credit system. Private credit portfolios carry substantially greater exposure to software, at approximately 22% versus 13% in the BSL index, according to Morgan Stanley’s Private Credit Tracker 4Q25. Furthermore, signs of direct lending strain — including increased use of payment-in-kind interest — were emerging well before AI concerns erupted. As private lenders turn inward to manage performance, their willingness to refinance weaker BSL issuers, particularly in vulnerable sectors like software, may diminish.
While a marginal withdrawal of private credit liquidity is unlikely to destabilise the BSL market, it may affect its weakest borrowers and their recovery prospects. Additionally, losses or liquidity needs in private credit could force sales of public credit assets.
Private market contagion is likely to spread
The idea that risks are neatly contained within private markets may turn out to be an oversimplification. For BSL investors, the private capital put is not guaranteed. A weaker refinancing market, more volatile loan prices and wider recovery dispersion may define the next phase of the credit cycle.
There is also an upside. A broad repricing of credit risk would be healthy, while increased BSL volatility could create opportunities to deploy capital at attractive levels. But those opportunities will not be evenly distributed. They will accrue only to CLO managers that stay in the game by actively preserving their deals’ structural integrity and maintaining credit discipline. They will retain the flexibility to act when others cannot.
