Private-Credit’s Reckoning: Why Gundlach Says the Next Crisis Will Be Off‑Balance‑Sheet — And How Investors Should Position Now

Gundlach’s core claim is blunt: the next big crisis is likely to erupt in private credit. He sees a market with speculative excess in the equity winners’ circle (AI‑linked names and data‑center bets) and a credit engine that looks disturbingly familiar to pre‑2008, with what he calls “garbage loans” and securitization dynamics that echo subprime. He characterizes the current environment as among the least healthy he’s seen, despite headline indices near highs earlier this month.

Private credit — largely direct lending by nonbanks to middle‑market companies — has swelled into a roughly $1.7 trillion market. Unlike bank loans that sit on regulated balance sheets with capital and liquidity requirements, these exposures often reside in funds, business development companies and vehicles that depend on investor confidence and continuous funding. Opacity is a feature: underwriting standards, covenants and loan marks are less transparent, and secondary liquidity can be fickle.

Gundlach’s critique stretches beyond underwriting. He zeroes in on distribution — the growing retail footprint of private‑credit funds that promise regular liquidity. If those promises collide with the reality of illiquid assets during a drawdown, managers could be forced into sales at steep discounts, accelerating mark‑to‑market losses and cascading stress through the broader nonbank ecosystem. It’s precisely this off‑balance‑sheet character — outside the traditional bank perimeter — that makes the risk harder to police and price.

The heart of the vulnerability is a structural mismatch: assets that are hard to sell quickly paired with investor terms that imply easy withdrawals. In good times, modest redemptions can be met from cash, credit lines, or selective secondary transactions. In stress, redemptions cluster. If gates or withdrawal limits are triggered, confidence can erode further — a dynamic seen in other alternative asset classes across cycles.

Gundlach’s concern about “garbage loans” points to late‑cycle underwriting creep. Debt packages that include PIK toggles, covenant‑lite structures, and generous add‑backs mask deteriorating interest coverage as base rates reset higher. If growth cools and refinancing windows narrow, borrower cash flows may no longer support debt loads, especially where EBITDA was padded by adjustments. The first cracks rarely show up at once; they appear in idiosyncratic failures, weaker sectors and highly levered profiles before bleeding into broader indices.

Off‑balance‑sheet is not just a metaphor. Because these loans are held in vehicles outside bank regulatory capital regimes, losses can propagate without the backstops and supervisory tools honed since 2008. That does not mean banks are immune — they are financiers to funds and counterparties to sponsors — but it shifts the locus of first‑order stress to nonbanks. The policy question becomes: if liquidity dries up and redemptions surge, who provides the brake? The answer is unclear, which is exactly the point of the warning.

The risk call is amplified by a murky policy backdrop. Markets have swung from near‑certainty of a December rate cut to less than even odds as Federal Reserve officials publicly diverged on the pace and necessity of further easing. That communication split, compounded by data gaps from the recent government shutdown, has injected what Chair Jerome Powell described as “descending fog.” When the driver can’t see, they slow down — and so do risk markets.

We’ve already seen how quickly sentiment can adjust. The S&P 500 recently logged its worst day in a month as rate‑cut hopes faded, with tech leading the selloff and small caps underperforming. Under the surface, tighter financial‑conditions regimes tend to widen credit spreads, crowd out marginal borrowers and shift the distribution of outcomes in credit from benign carry to downside skew.

The yield curve itself has been normalizing from its long inversion. As of mid‑November, the 10‑year Treasury yield sits around 4.14%, versus roughly 3.62% for the 2‑year, leaving a positive spread near 50 basis points. A de‑inverted curve can relieve some recession signal anxiety, but the level of rates remains restrictive for many leveraged borrowers. If the market prices fewer/fatter cuts ahead, funding costs stay elevated longer — a headwind that matters most for floating‑rate capital structures so common in private credit.

Stress rarely starts in private markets’ performance marks; it shows up first in day‑to‑day payment frictions. Foreclosure activity, while still below historic norms, has now risen year‑over‑year for eight consecutive months. October data showed a 19% annual increase in overall filings, with starts up 20% and completed foreclosures up 32%. The geographic distribution is not uniform: Florida, South Carolina and Illinois lead on filings, while Texas, California and Florida dominate completed foreclosures — a pipeline that can feed distress inventory.

Household balance sheets tell a bifurcated story. Aggregate household debt hit a record $18.59 trillion in the third quarter, with mortgages at $13.07 trillion, credit cards at $1.23 trillion and student loans at $1.65 trillion. Overall, 4.5% of outstanding debt is in some stage of delinquency. The more telling figure for late‑cycle dynamics is the share in serious delinquency (90+ days), which rose to 3.03% in Q3 from 1.68% a year earlier, with student loan reporting resumption adding volatility. The Federal Reserve has leaned into the “bifurcated economy” narrative: higher‑income households continue to spend, while lower‑income consumers downshift to cheaper goods.

Small businesses, a traditional canary for credit conditions, are contending with higher wages and still‑elevated borrowing costs. That pressure bleeds into supply chains and service sectors where floating‑rate lines are the norm. If softening demand meets high carrying costs, defaults typically follow a predictable order: subprime consumer, then small‑business and lower‑quality corporate credits, before edging into higher‑quality tiers if the slowdown endures. None of this guarantees a hard landing, but the directionality is consistent with a maturing cycle.

Gundlach’s tactical playbook is stark: hold roughly 20% in cash and keep a meaningful, but trimmed, allocation to gold (about 15%). He explicitly avoids shorting junk bonds despite his worries — a nod to how costly “obvious” negative carry trades can be when liquidity remains plentiful. The through‑line is optionality: dry powder to buy when illiquidity creates forced sellers, and hard assets as a hedge against policy and geopolitical surprises.

For portfolios, that translates into a few practical steps. First, prioritize genuine liquidity. A T‑bill ladder or short‑duration high‑quality cash alternatives can preserve optionality without sacrificing all yield; with front‑end Treasury yields still near 4%, carry is not negligible. Second, avoid momentum in overheated pockets — not just in equity AI plays where expectations are extreme, but also in private‑credit funds that rely on smooth marks and stable inflows. Third, favor balance‑sheet quality: investment‑grade credit with shorter duration and clear cash‑flow visibility can weather higher‑for‑longer funding costs better than leveraged structures.

Finally, build and maintain a clear risk‑trigger dashboard. Watch foreclosure starts for an acceleration, credit spreads for widening beyond recent ranges, fund‑level gates or withdrawal frictions in private vehicles, and the Fed signaling regime. A hawkish‑leaning pause or messaging that resets the path of cuts tighter can tighten financial conditions mechanically. If several triggers flash at once, de‑risk faster; if they calm, redeploy selectively into dislocations.