The recent defaults of First Brands Group and Tricolor Auto Group have prompted renewed scrutiny of the credit markets, particularly around underwriting standards and investors discipline. While initial market reaction has centered on the broader implications for credit market health, a closer examination suggests these events are primarily idiosyncratic in nature, underpinned by possible capital structure mismanagement and a lack of effective governance, rather than being symptomatic of broader macroeconomic or late-cycle dynamics. In the case of First Brands, creditors balked at last-ditch refinancing proposal—but by then, the structural weaknesses in the balance sheet had become irreparable. The credit failures have left investors facing substantial losses and underscore how excess liquidity, willing to overlook structural risks, and yield-seeking behavior have encouraged risk tolerance well beyond conventional thresholds. Several high-profile institutional investors were exposed to the defaulted names, not due to systemic contagion, but rather a breakdown in bottom-up credit investment discipline. While some have sought to frame these events within the context of tighter financial conditions and a decelerating economy, such arguments obscure the fundamental issue: the credits were flawed by design, marked by dubious reliance on asset-backed securities structures and aggressive receivables-based lending solutions that masked underlying cash flow weaknesses and structural vulnerabilities. That said, these failures have contributed to a broader repricing across segments of the leveraged finance (the companies’ failures triggered a selloff of loans in the automotive and consumer financials sectors) and private lending markets, where investors selectivity is rising and limited partners (LPs) are increasingly requesting visibility into watchlist names and conducting more granular line-by-line portfolio reviews (let’s see how long this lasts). The lack of transparency in private credit portfolios has begun to unsettle some investors, who are now waking up from a period of complacency, previously comforted by credit managers’ reassurances and optimistic comments. Moreover, concerns have started to surface around the vulnerability of mid-sized U.S. lenders, raising the specter of a potential replay of the 2023 regional banking crisis. While not systemic at this stage, sentiment has clearly deteriorated, with credit spreads drifting wider across specific subsectors. In Europe, credit markets have not been immune. Over the past two weeks, investor sentiment has softened, with limited insight on a clear catalyst. However, the shift in risk appetite has led to notable de-risking in cyclical sectors, particularly chemicals, and increased spread pressure on specific names flagged for potential downgrade due to weakening operational performance, negative free cash flows, and elevated leverage metrics. The prevailing nervousness highlights how swiftly the market is penalizing credits with deteriorating fundamentals, particularly those facing significant refinancing needs over the next 12–18 months and whose debt is trading at greater than 10% yield-to-worst (YTW). In some cases, the distress is not solely driven by credit KPIs but is amplified by self-fulfilling prophecies. With most commentary centered on the usual pressure points in credit markets, it’s time to focus on issues that have flown under the radar but carry meaningful implications. One of the most overlooked issues is that credit deterioration among several European issuers is not a recent phenomenon. A few credits have been underperforming operationally for multiple quarters. Metrics such as leverage, interest coverage, and free cash flow have long signaled unsustainable trajectories, yet markets have been slow to react. Concerns around credit strength should have emerged far more forcefully during the second-quarter earnings season, which—as noted in my previous commentaries—was broadly disappointing across both cyclical and defensive sectors. The market’s delayed recognition (or action) of these risks has created a false sense of stability, now unraveling as spreads start to widen and pricings adjust. I have identified several recent bond issuances that have come to market at excessively tight levels and are rightly trading soft. At the same time, the functioning of the European leveraged loan market is increasingly shaped by technical drivers—particularly from the CLO ecosystem as highlighted in the last Barclays’ research—rather than issuers fundamentals. The loan prices are being driven by structural features within CLOs: forced selling at the last moment in response to CCC downgrades, mechanical buying of specific names especially those with high spread and those recently appeared in primary, and price dislocations where certain loans trade above par despite weak credit profiles. These dynamics are introducing volatility, price swings, and valuation inconsistencies at a scale that has no real precedent. In this environment, the traditional approach to managing leveraged loans—relying primarily on bottom-up credit selection—has become insufficient. Leverage loan investors must now incorporate a deeper understanding of CLO portfolios, including large managers positioning, credit concentrations, and downgrade sensitivity of underperforming credits in the portfolios spanning both new and seasoned vintages and those within or beyond their reinvestment periods. The price range between €60 and €80 in secondary loan markets has become a notoriously illiquid zone, with limited appetite from the CLO machine. Below €60, loans are generally considered distressed, often implying that a restructuring or a significant capital event affecting the credit is approaching. These price levels now act as market signals, defining the boundaries of liquidity and recovery expectations. Importantly, what we're witnessing is not merely a cyclical shift, but a structural transformation of the leveraged loan market itself. The space has absorbed a large volume of weaker credits over recent years, drawn by the loan market’s borrower-friendly dynamics and persistent demand from CLOs. The competition for assets has placed downward pressure on underwriting standards, pricing discipline, and documentation quality. In effect, loans have become the preferred venue for “marginal credits”—corporates that would have struggled to access the bond market at good pricing levels or raise traditional financing on favorable terms. Since mid-2024, there has been a steady migration of lower-quality borrowers from the private credit market into the broadly syndicated loan (BSL) market. Consequently, today the loan market remains probably misaligned with the underlying credit risk of many borrowers. The corporates remain excessively clustered within a narrow 25-35 basis point range, indicating limited credit differentiation. Over the past several months, European leverage loans (look at the ELLI) have underperformed the high-yield bond market, a divergence largely explained by the weaker average credit quality in the loan space. This difference in performance is essential when constructing new portfolios or marketing strategies to potential clients. Not all sub-investment grade assets are equal, and credit selection within the leveraged loan universe is now more critical than ever. While CLOs remain broadly stable at the structural level—particularly senior tranches, which continue to benefit from robust credit enhancement—portfolio dispersion across managers is widening. Equity payments vary significantly by manager, and certain portfolios are beginning to underperform. In several cases, and based on my estimates, some CLO resets have eroded the equity holders’ relative position and could eventually put pressure on mezzanine tranches as well. The erosion in credit quality across collateral pools is starting to show in tranche-level spread behavior. BB and B tranches, which have long appeared rich relative to underlying risk, are beginning to widen slightly. BBB spreads remain anchored around 300-310 bps for now, but growing concerns over potential widening may complicate the pricing of capital stacks in the primary market. This introduces additional uncertainty—particularly for investors trying to assess relative value across the structure. Default risks should not be the primary concern for CLO investors; instead, the focus should shift toward liability management exercises (LMEs), protracted recovery timelines for restructured credit exposures (if any), and the par erosion or creation accumulated in the management of the portfolios. Passive ownership of CLO liabilities is no longer a viable strategy—even at the upper levels of the capital stack. Vigilant credit monitoring and rigorous manager scrutiny are now essential, as fundamental weakness among borrowers in the underlying asset pools continues to build. Liability-side investors—particularly those exposed to mezzanine risk—must actively evaluate manager style, tail-risk exposure, overweighted and underweighted sectors, and deteriorating portfolio dynamics, especially rising CCC concentrations, MVOC metrics, and NAV levels. Equity investors, of course, face an even more complex set of challenges and handle difficult estimates (I have described them in the last text written before the CLO conference held in London in October). In Europe investors are not facing the same leverage loan market as in past cycles. The rules have changed. Navigating today’s landscape demands a fundamentally different approach—one grounded in discipline, real-time surveillance, and a clear-eyed assessment of how CLO vehicles increasingly shape loan prices and underlying leverage loan market dynamics.

Autumn or winter in the credit market, the European leverage loans and CLOs: Cold weather is setting in