European Leveraged Loans Outlook 2026 – Beware of the CCC: Cockroaches, Collateral, and Covenant Creep

Technical support from Collateral Loan Obligations (CLOs) and non-traditional investors persists, but caution is warranted. Downgrades are rising and valuation bifurcation is deepening. Within corporate credit's sphere, however, "cockroaches" are emerging. Early warning signs of irregularities, weak controls, and diluted covenants appearing at the margins, signal the need for sharpened credit selectivity, not systemic alarm, in our view.

2025 European loans review

Performance: carry, not rally

After a 16-month run of positive returns, the European loan market recorded its first drawdown in March 2025. That setback reflected the beginning of the US imposition of tariffs on China, Mexico and Canada, with the focus on steel, aluminium and automotive imports. Volatility returned in October (another drawdown month), as private credit concerns intensified, following press coverage of the collapse of automotive groups, First Brands and Tricolor, and reports of fraud at some US regional banks.

“Loans produced solid returns for 2025”
 

As the year progressed, despite those shocks, the market regained momentum and delivered steady gains across subsequent quarters. Indeed, loans produced solid returns for 2025 (4.00%). However, these gains failed to match the European high yield (5.35%), which benefited more directly from the c.100 basis points (bps) of rate cuts delivered by the European Central Bank (ECB). With inflation and base rates now close to ECB targets, longer-duration fixed-rate assets are unlikely to enjoy the same tailwinds. Against a backdrop of volatile macro signals and abundant issuance, secondary loan prices finished the year just over 100 bps lower. Consequently, returns over the year were driven largely by carry, not by broad‑based price rallies.

Issuance & Pricing: mega deals and compressed spreads

Gross European loan issuance exceeded €235 billion in 2025, ostensibly a post-Global Financial Crisis (GFC) record excluding 2021 post-Covid catch up. However net new issuance (whether from buyouts, recaps or add-ons) was far more modest, accounting for less than 30% of total issuance. Importantly, at €64bn, it was also 36% lower than the volume of loans seen in the buyout boom of 2021. 

“M&A volumes increased 41% YoY”
 

Wider M&A activity is the most significant driver of new loan issuance. A surge in megadeals in the second half of the year (deals valued over $10bn), saw overall M&A volume increase 41% YoY to $4.81tn (Mergermarket as of 15 December 2025), in line with 2021’s high, which was welcome. This is a positive leading indicator for loan market issuance in 2026. In our view, this rebound included the largest leveraged buyout in history: SilverLake and Affinity Partners’ agreement to acquire Electronic Arts for $55 billion.

Despite the apparent abundance of issuance, net supply in 2025 was limited. Refinancing dominated activity whether in tenor extensions, resets or repricings. Net technical undersupply was even more pronounced particularly when considering that CLO issuance set a new record, topping €60 billion, with another €63 billion of resets on top of that.

Although these conditions compressed new-issue spreads by around 30 bps over the course of the year albeit European primary margins remained higher than those of the US. By contrast, secondary spreads were flat at c.470bps, revealing the dispersion of credit risk inherent in the outstanding universe. Again, Europe preserved its premium to the US loan market.

US v Europe: cochroaches, collateral and covenant creep

Recent headlines have tried to stitch together a story of systemic fragility in private credit, linking the First Brands collapse with Tricolor’s distress and fraud cases in US regional banks. However, these events were largely idiosyncratic rather than evidence of inherent, wide-scale fault-lines. First Brands reflected governance failings and alleged factoring fraud, while Tricolor’s issues stemmed from subprime auto-loan ABS, i.e. a consumer credit problem rather than corporate loan contagion, and fraud in US bank commercial real estate portfolios sits in yet another risk-silo. 

“The fundamentals for European leveraged loans remain intact”
 

However, the perceived connection is mostly psychological, as the coincidence of defaults and fraud dented confidence, fuelling calls for tighter oversight of non-bank lenders, even though private credit as a whole is not failing. The fundamentals for European leveraged loans remain intact, thanks to inherent lender protections, further, bottom-up credit analysis and operational diligence matter far more than sensational headlines.

European Loans have historically exhibited lower default and distress rates than US Loans. Over the last twelve months, the European loan par default rate was around 1.1% versus 1.3% in the US (Pitchbook November 2025). When aggressive US Liability Management Exercises (LMEs), such as non‑pro‑rata uptiers and drop‑downs, are included, the US default figure triples to about 3.7%, underscoring a materially higher effective impairment environment for US lenders.

LMEs, typically executed out of court, by exploiting loose documentation and low voting thresholds, have been far more pervasive in the US than in the European loan market. In Europe, where stronger norms of pro‑rata treatment, clearer director duties, and more conservative use of collateral, these have acted as a brake on such tactics. The crowded and competitive nature of the US market often means being the most accommodative lender can be key to winning deals. This is highlighted by the fact that US covenant trends are more borrower-favourable, with higher absolute levels of EBITDA adjustments and greater scope to make them throughout the loan’s life in the (looser) documentation.

“A lower distress ratio, tighter protections and more disciplined covenants underpin the relative outperformance of European loans”
 

Europe’s more balanced restructuring and documentation framework supports better outcomes, limiting covenant creep and collateral leakage. Tools such as English Schemes of Arrangement and Restructuring Plans offer predictable, creditor-aware paths to restructure, even if also outside of formal court processes, often at lower cost than Chapter 11. Sponsor and lender culture generally resists aggressive (non-pro-rata) LMEs. We believe a lower distress ratio, tighter protections and more disciplined covenants underpin the relative outperformance of European loans and strengthen the case for allocations to the asset class.

2026 Outlook

Performance

European Loans are positioned to outperform European High Yield and US Loans over the medium term, with expected gross returns of around 7% versus 5% and 6% respectively. With European inflation and policy rates now close to target, it is unlikely that longer-duration, fixed rate assets will continue to benefit from the same degree of base-rate compression that was seen in 2025.

On a gross basis, we continue to observe a consistent return premium of more than 100 bps for European Loans relative to European high yield. Adjusting for credit risk impairments (defaults of 3% for European Loans and 5% for high yield, and assumed recoveries of 60–70% and 40–50% respectively), widens the risk-adjusted premium yet more, to about 300 bps. Likewise, adjusting for US Loan defaults of 5% and recoveries of 60-70% (perhaps an optimistic assumption given the prevalence of Liability Management Exercises), we see a doubling of the return premium being offered by European Loans to 120 basis points¹.

We believe this is compelling, particularly given the structural advantages of senior secured loans, including first‑lien status and security over assets of value that belie the rating differential between the two markets.

Beware of cockroaches, collateral and covenant creep

The wave of repricings and refinancings has demonstrated the loans market’s ability to self-regulate and consequently the “maturity wall” is no longer a major concern. Furthermore, aggregate credit metrics have improved: interest coverage ratios having climbed to 3.5x from 2.8x over the past two years, while both total and senior leverage levels sit below 5x.

However, averages can be misleading since bifurcation persists: while 63% of loans trade at or above par, some 10% trade below 90, indicating some level of difficulty, if not stress, may be inherent in the companies concerned. Furthermore, the rating ‘downgrade:upgrade ratio’ has increased, from 1.9x to 2.7x, albeit remaining far lower than 2018-2020 (average 7.5x).

“Discipline and selectivity remain of paramount importance”
 

More than 5% of loans trading below 90 are rated CCC or lower too, up from 3% last year – a rating band that sees default as having a 50/50 probability. Focusing on this weaker subset, it is reasonable to infer that today’s default rate of 1.1% could rise – perhaps towards 2.5–3%, the European loan market forecast of Fitch Ratings. This underlines why discipline and selectivity remain of paramount importance in actively-managed loan portfolios.

CLO boom: new players rush in

Primary European CLO issuance reached a record high in 2025, nearing €60 billion, with market activity boosted further by numerous resets and refinancings. The outlook for 2026 remains positive with momentum expected to continue: there are around 150 open CLO warehouses and an increasing number of new managers entering the market.

However, the market’s full potential hinges on two main developments: a steady increase in new loan supply and lower funding-costs for CLO liabilities, which would enhance CLO equity arbitrage opportunities. As CLO liability-pricing, especially for AAA tranches, has remained stubbornly wide, while asset spreads have tightened, a sustainable market balance will require both an increase in loan supply and associated margins, or an adjustment in liability-pricing to allow managers to achieve more attractive levels of ‘day one’ arbitrage for CLO equity investors.

The return of M&A?

Despite high expectations for 2025 deal-making potential, private equity led activity, in line with the overall M&A scene, ultimately disappointed. The year began with a reducing gap between buyers and sellers, a pre-requisite for advancing deal activity. Unfortunately the US administration’s tariff announcements in Spring introduced uncertainty over prospective valuation multiples, a factor which persisted for most of the year, ultimately suppressing M&A activity.

“The loan market not only needs more deal flow, it needs diversification of deal flow”
 

Further, 2025’s anaemic deal flow failed to satisfy the appetite for loans. At this point, the market requires more debut issuers in order to maintain equilibrium over the long term, ideally from new buyouts if not acquisitions by existing LBO companies. In the absence of this, refinancing from other markets could bridge a gap. This was the dynamic seen in 2024, when big direct lending issuers largely refinanced into the syndicated loan market.

The loan market not only needs more deal flow, it needs diversification of deal flow. 2025 was dominated by TMT and, within that, Software, already the largest sector and one likely to be affected most directly by AI (see below). With public equity markets being narrowly dependent on a handful of AI companies, this is the sector whose double-digit valuation multiples may be most at risk from an AI bubble bursting in 2026.

That said, 2026 looks brighter when it comes to the prospect of sizeable deployment of PE dry powder. Furthermore, with the increasing establishment of continuation vehicles, whether for multiple or single assets, there is reduced fear of fire-sales, creating a better chance of minimizing valuation gaps between buyer and seller. Assuming no more political or fiscal curve-balls, M&A action is expected to increase this year.

AI capex: a trillion dollar feast

Technology has long been a sponsor staple sector, with traditional sub-segments such as customer services, human capital management and supply-chain amelioration being buyout favourites. Having said that, AI has reshaped the lens through which technology investments must be viewed. The most immediate impact of the effect of agentic AI has already been seen in the valuation of business services companies, such as call centres, where enterprise value (EV) multiples halved in 2025 with fears of their future obsolescence. However, this may be overdone as it is not clear that agents can entirely replace humans, nor that the companies concerned cannot harness the power of AI to their benefit.

In Software, one of the largest sectors in the loan market, constituent companies are typically integrated (ERP) and business-process providers of mission-critical services, such as accounting and payroll processing, often in industry verticals. These are areas likely to be resistant to the risks that AI could bring, specifically inaccuracy and error, requiring multi-year development and implementation capabilities. 

“Owning the data from which agentic AI can be trained is a potential source of efficiency for those companies seeking to embrace and invest in working with AI”
 

That agentic AI could replace customer services in other sectors, e.g. Healthcare, is also a risk, but, again, there will be barriers – employee resistance, subpar outcomes, multi-year development needs and regulation to name a few. Owning the data from which agentic AI can be trained is a potential source of efficiency for those companies seeking to embrace and invest in working with AI. Leverage thresholds being tighter, cashflow defensibility being evidential, and contagion risks from adjacent sectors being minimized, are all deal-features demanding scrutiny from here.

More than $1.5 trillion in AI capex has been announced for the next five years, with more likely to come, in order to fund the infrastructure need for data centres, power and chips. While only a modest amount of the front-line need may be expected to come from sponsor-owned companies in the syndicated loan market, it is estimated that in excess of $150 billion will come from non-IG (Investment Grade) debt markets more generally, potentially having secondary effects on (wider) loan-pricing. Indirect beneficiaries in the loan market may include companies active in cooling, fibre and construction services that may increasingly utilise leveraged finance markets, offering welcome supply. 

Companies that successfully harness AI to streamline their operations, could improve margins and free cash flow, supporting their deleveraging and protecting their EV over time. However, narrowly-focused AI infrastructure stories, with outlandish projections, could combine high upfront capex with execution risk and uncertain end-user demand. Add aggressively-adjusted EBITDA calculations and overly-loose documentation and the screening-out of such transactions may well become a pre-requisite for a well-managed loan portfolio.

Conclusion

European Loans enter 2026 with a benign economic backdrop, healthy fundamentals and supportive technicals, though a number of visible challenges reinforce the need the need to remain selective. Repricings and refinancings have pushed the “maturity wall” out and improved top‑line metrics. Strong CLO demand, fanned by new managers, continue to support the asset class, as long as loan-supply and liability-costs move into better balance. 

At the same time, a weaker tail of credits, creeping covenant flexibility and pockets of concentration risk, including AI‑related capex stories and more complex collateral structures, mean outcomes are likely to diverge more sharply. In this environment, investors combining rigorous, bottom‑up credit analysis with a disciplined approach to covenants and collateral, should be well placed to capture attractive, default-adjusted yields of 6% plus (in euro terms) in the year ahead.
 

¹ The scenarios presented are an estimate of future performance based on evidence from the past on how the value of this investment varies, and/or current market conditions and are not an exact indicator. What you will get will vary depending on how the market performs and how long you keep the investment/product.