The leveraged loan market is experiencing a complex repricing dynamic as spreads have compressed to historically tight levels while covenant protections have simultaneously eroded. As of June 2025, the discounted spread to maturity in leveraged loans stood at 399 basis points, below the long-term average of 449 basis points [3]. This compression occurs despite fundamental concerns about credit quality, creating a disconnect between pricing and underlying risk that secondary market mechanisms are only partially addressing.
Spread Compression and Risk Premium Dynamics
The current pricing environment reflects a paradoxical situation where risk premiums appear insufficient relative to deteriorating credit fundamentals. As of June 2025, leveraged loan indices offered yields near the 70th percentile of the past 10-year period, with excess yield versus US high yield bonds remaining well above the 10-year average [2]. However, when adjusted for quality differences, the spread differentials between BB and B-rated loans versus comparable high-yield bonds show a higher credit risk premium being priced into loans compared to historical averages, reflecting recent market headwinds including higher defaults and increased supply [2].
The four-year discount margin in loans has been slightly below 10-year median levels over the past two quarters, while unadjusted leverage for new issues has stayed near median levels, suggesting loans are reasonably priced compared to their history [2]. Yet this assessment masks significant structural changes in the market composition and covenant quality that traditional spread metrics may not fully capture.
Covenant Deterioration as a Pricing Blind Spot
The most critical disconnect between secondary market pricing and actual credit risk stems from the dramatic loosening of covenant standards. Covenant-lite loans have increased from less than 20% to more than 90% of issuance as of June 2025 [3]. These loans lack maintenance covenants that traditionally provided early warning signals of deteriorating credit quality. The shift toward single-covenant deals—typically featuring only a leverage test—further reduces lender visibility into borrower financial performance [4].
This covenant erosion is particularly pronounced in larger transactions. Analysis by S&P found that some borrowers maintain substantial covenant headroom not because of strong performance, but because debt-to-EBITDA covenant thresholds were set at extremely high levels (8x, 10x, or 12x), rendering them ineffective as early warning mechanisms [6]. Secondary market pricing has not fully adjusted to reflect the loss of these traditional monitoring tools, creating a structural information asymmetry where price discovery mechanisms operate with degraded real-time credit quality signals.
Private Credit's Market Share Expansion and Pricing Implications
Private credit lenders now account for approximately 69% of all leveraged loans outstanding as of June 2025 [3], a significant shift from traditional bank lending. These lenders operate with greater flexibility and customization but often employ less standardized documentation and reporting standards. The secondary market for private credit loans is substantially less liquid than traditional syndicated loans, with pricing often determined through bilateral negotiations rather than transparent market mechanisms.
The expansion of private credit has introduced new structural features, including priority revolving facilities within unitranche loans that create complex repayment hierarchies [4]. Secondary market pricing of these instruments must account for embedded optionality and priority structures that are not always transparent to all market participants, potentially leading to mispricing of subordinated tranches.
Early Warning Indicators for Institutional Investors
Institutional investors should monitor several key indicators to identify potential mispricing before widespread defaults materialize:
Leverage Trajectory and Covenant Headroom Analysis. While net leverage in new loan issuances remained below the ten-year average as of Q1 2025 [2], investors should track the divergence between reported leverage and effective leverage (adjusted for covenant definitions). The prevalence of high-threshold leverage covenants means traditional leverage metrics may understate actual financial stress. Monitoring quarterly covenant compliance reports and tracking the frequency of covenant amendments or waivers provides early signals of deteriorating credit quality not yet reflected in secondary market prices.
Default Rate Acceleration Relative to Spread Levels. The leveraged loan trailing 12-month default rate rose to 5.0% in September 2025 from 4.8% in August [7]. Secondary market spreads should be compared against forward-looking default rate expectations. When spreads remain compressed despite rising default rates, this indicates mispricing. Investors should establish trigger levels where spread-to-default-rate ratios fall outside historical ranges, signaling potential repricing events.
Covenant-Lite Loan Performance Divergence. As covenant-lite loans now represent over 90% of issuance, their performance relative to covenant-heavy loans becomes a critical pricing signal. Secondary market trading volumes and bid-ask spreads for covenant-lite versus covenant-heavy loans of similar credit ratings should be monitored. Widening spreads between these categories suggest the market is beginning to price in the information disadvantage created by reduced covenant protections.
CLO Composition and Reinvestment Pressure. CLOs account for roughly 69% of all leveraged loans outstanding [3], creating structural demand that may artificially support secondary market prices. Monitoring CLO reinvestment schedules, particularly during periods of rising defaults or spread widening, helps identify when forced selling or buying pressure may distort secondary market pricing. CLO manager behavior during stress periods often precedes broader market repricing.
Sector-Specific Stress Indicators. Anticipated defaults are expected to be driven by sector-specific issues in government, healthcare, industrial, and other sectors [5]. Secondary market pricing should be disaggregated by sector, with particular attention to industries showing deteriorating fundamentals relative to their loan spreads. Sector-level repricing often precedes broader market adjustments.
Structural Mispricing Risks
The combination of spread compression, covenant deterioration, and private credit market expansion creates several mispricing scenarios. First, the secondary market may be underpricing the information disadvantage created by covenant-lite structures, as traditional spread models assume access to regular covenant compliance data. Second, the heterogeneity of private credit documentation standards means secondary market pricing may not adequately differentiate between loans with varying levels of lender visibility. Third, the concentration of loans in CLO structures creates structural demand that may support prices above fundamental levels, with repricing risk concentrated in periods of CLO stress or redemptions.
Institutional investors should implement systematic monitoring of these early warning indicators, recognizing that secondary market pricing mechanisms are less efficient in the current environment due to reduced covenant transparency, increased private credit participation, and structural demand from CLOs. The current pricing environment suggests moderate mispricing risk rather than classic bubble conditions, but the deterioration in information quality and covenant standards means repricing events could be more abrupt and severe than historical experience would suggest.
