Investment Strategy

Is trouble brewing in Private Credit markets?

Private Credit – Direct Lending plays a vital role in financing small and mid-sized private businesses that often lack access to public debt markets. These companies represent a growing segment of the economy and have continued to drive demand for new loans. However, recent high-profile bankruptcies in the automotive sector have raised investor concerns about potential stress, fraud, and contagion within private credit markets.

It is important to contextualize these events. The two bankruptcies in question were primarily financed through public debt channels, with limited exposure to private direct lending. Despite this, publicly traded business development companies (BDCs), which are commonly used vehicles for private credit strategies, experienced notable declines. According to iCapital’s analysis of over 160 public and private BDCs, the exposure to these borrowers was minimal, representing just 0.05% of assets under management across 166 funds.¹ Most BDCs had no direct exposure at all, suggesting the market reaction may have been disproportionate to the actual risk.

Assessing the health of private credit

While isolated pockets of stress exist in Direct Lending — particularly among lower-quality borrowers — there has not been evidence of widespread deterioration in credit conditions to date. Private Credit – Direct Lending has demonstrated resilience amid elevated interest rates and higher debt servicing costs. One key indicator of market health is the percentage of loans marked below 90% of par value (see Chart 1). As of the latest data, only 5.2% of loans fall into this category, down from 7.4% in first-quarter 2023. Sectors showing elevated stress include retail (12.5%), transportation (8%), automotive (9.5%), general manufacturing (8%), and construction (8%).² Although overall stress levels remain contained, recent quarters have shown a rising trend in the proportion of impaired loans. Should economic conditions weaken further, this metric may continue to deteriorate.

Chart 1. Direct lending term loans marked less than 90% of parSources: Cliffwater LLC, data as of June 30, 2025. CDLI definition at end of report. Performance data represents past performance, which does not guarantee future results. There is no assurance that similar investments will be made or that similar results will be achieved.

Additional indicators also suggest stability. Loans in non-accrual status — where borrowers have ceased interest payments and are considered in default — remain well below historical peaks. Following past economic downturns and the pandemic-induced spike in 2020, default levels have since stabilized and even declined (see Chart 2).

Another measure, the use of payment-in-kind (PIK) loans — where borrowers pay interest in additional principal rather than cash — has remained steady in recent years. While elevated from pre-pandemic levels (below 6%), current usage does not indicate a systemic issue. PIK loans can be a temporary solution for borrowers facing liquidity challenges, but they also warrant close monitoring as they may signal underlying credit stress (see Chart 2). In general, growing usage of PIK interest would likely warrant further caution as it may be a sign of deteriorating business fundamentals.

Chart 2. Direct lending non-accruals/defaults and payment-in-kind income trendsSources: Cliffwater. Payment-in-kind income as a percentage of income generated in the Cliffwater Direct Lending Index. Non-accruals loans are those that are no longer current in paying interest income, defined as missing payments for 90 days or more and would be considered in default. Non-accruals are shown at loan cost as a total as a percentage of the total CDLI index value. Data as of June 30, 2025.

Macroeconomic outlook and investment implications

We maintain a neutral stance on Private Credit — Direct Lending, as we look for the economy to continue to navigate a period of slower growth and tariff-induced uncertainty. However, most indicators point to a stable credit environment. Looking ahead, our expectations for improved economic growth and lower short-term interest rates in 2026 should support borrower fundamentals and enhance creditworthiness.

We believe Private Credit remains a compelling component of a diversified portfolio, offering attractive income potential. Nonetheless, investors must remain cognizant of the inherent risks. Small and mid-sized borrowers carry higher credit risks relative to investment grade corporate fixed income markets and are vulnerable to prolonged economic downturns or recessionary pressures. We believe investors should consider using professional money managers that employ a disciplined approach to underwriting and structuring loans, which can help mitigate risks. While our outlook for 2026 suggests a gradual economic recovery, we believe it is prudent to maintain a neutral in Private Credit – Direct Lending space until economic uncertainty subsides and growth momentum strengthens.

Alternative investments, such as hedge funds, private equity, private debt and private real estate funds are not appropriate for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws.

¹ iCapital Market Pulse: Behind the Recent Private Credit Noise, October 17, 2025 by Sonali Basak, Peter Repetto, Nicholas Weaver, and iCapital Investment Strategy Group.

² Cliffwater – Featured Analysis commentary. Data as of October 27, 2025.

Systems software leads in AI buildout era

AI continues to dominate technology investment flows, with capital heavily concentrated on infrastructure buildout, particularly semiconductors and data center components. Software remains integral to digital transformation; however, investor sentiment has shifted as questions arise about whether AI will erode competitive moats, commoditize SaaS offerings, and disrupt parts of the enterprise stack. While disruption is not uniform across the software space, we believe the “AI will kill software” narrative seems overstated. In our view, application software appears more vulnerable to displacement, while systems software seems more durable and better positioned.

We believe systems software is emerging as the structural winner in the current environment. Solutions, such as data platforms, workflow automation, and cybersecurity are critical for AI workloads that demand scalable compute, secure environments, and robust data pipelines. This trend is reinforced by massive AI infrastructure commitments, including the $500 billion Stargate Project.

Conversely, application software faces a more challenging outlook. Front-office solutions, such as customer service platforms, appear more vulnerable to commoditization and displacement. Generative AI is pressuring pricing power for niche SaaS offerings, but leaders embedding AI into workflows are better positioned to defend market share.

Valuation trends reflect this divergence, as systems software multiples remain resilient, while application software valuations have lagged amid moderating growth expectations. Overall, we maintain a constructive view on software, but we favor systems software companies that offer sticky, mission-critical solutions over single-point offerings. We are selective within Application Software, favoring leaders that are integrating AI at scale.

Chart 3. System software valuations support AI infrastructure buildoutSources: Wells Fargo Investment Institute and FactSet. Data as of October 27, 2025. P/Sales - NTM = Price-to-Estimated Next Twelve Months Sales.

School district bonds: Stability amid fiscal strain

In fiscal-year (FY) 2023, U.S. school districts received $981.9 billion in funding, primarily from state (43.9%) and local (43.2%) sources, with property taxes contributing 27.5% on average. Federal funding accounted for 12.9%, elevated due to pandemic relief but is expected to revert to historical levels (approximately 7.8%).

Chart 4. Fiscal-year 2023 school district revenue sourcesSources: National Center for Education Statistics. Data as of August 2025.

Credit conditions are showing early signs of stress. The expiration of federal aid, rising costs, and declining enrollment are pressuring budgets. In 2023, the S&P 500 reported a 40% increase in negative outlooks, and Moody’s noted a drop in median fund balances to 27.2% of revenues.

Despite these challenges, school district bonds continue to exhibit relatively stable credit profiles due to strong structural protections. Most general obligation bonds are backed by unlimited property tax pledges, legally mandated to cover debt service. These funds are segregated from operating budgets, somewhat insulating bondholders from fiscal strain. Lease revenue bonds and certificates of participation, while riskier, can still be solid investments when tied to essential assets.

State enhancement programs further bolster credit quality and reduce borrowing costs. These include guarantees, state aid intercepts, and permanent funds, often resulting in higher bond ratings and better market pricing. Enhanced bonds typically trade at higher relative levels compared to unenhanced debt.

While we believe sector-wide defaults are unlikely, investors should monitor individual district credit quality and state-level support mechanisms to manage risk effectively.

REIT sub-sector performance remains volatile

We have noted in the past that REIT performance often varies significantly from one sub-sector to another, and the first three quarters of 2025 was no exception with total returns across the 17 REIT sub-sectors again demonstrating variability, ranging from 26.70% (Health Care REITs) to -9.57% (Data Center REITs).

Health Care REITs are the top performing sub-sector in the first three-quarters of 2025 and appear to be benefitting from continued solid resident demand for modern senior living properties in many major cities — a trend we attribute to the aging Baby Boomer generation (see Chart 5). We view free standing retail REITs as a beneficiary of lower interest rates and defensive characteristics, namely stable occupancy, consistent cash flows, and dividends. Finally, we attribute the stronger relative returns for regional mall REITs to reasonable U.S. economic growth along with a low unemployment rate, factors that have given consumers — especially higher income shoppers — the confidence to continue spending on discretionary goods.

Among the weaker-performing REIT sub-sectors in 2025, Data Centers stand out. While being a top performing sub-sector in 2024, investor sentiment towards these REITs cooled this year, likely due to several high-profile news items such as DeepSeek and reports of a large hyperscaler slowing its data center expansion plans. For lodging and resort REITs, they are likely underperforming due to lower in-bound international travel volume, which is likely an outcome of changes in U.S. immigration policy and enforcement. After generating solid returns in 2024, residential apartment REIT returns are among the lowest in the REIT industry during 2025. We believe the slowing U.S. job growth along with weaker reported apartment rental rate increases are impacting apartment REITs.

As of September 30, 2025, equity REIT year-to-date total returns are modestly positive (4.51%) and roughly in line with the total returns (4.92%) generated in 2024. We remain neutral on the Real Estate sector given REITs potential defensive positioning offset by possible impacts from lower interest rates. Further, we would highlight the significant variability in returns by sub-sector.

We recommend investors considering REITs focus on Data Center and Industrial REITs, given positive long-term demand drivers. Looking ahead, we believe Telecommunication REITs could be a beneficiary of potential interest-rate reductions in late 2025 and 2026, along with continued growth in mobile data consumption and the continuing rollout of fifth-generation (5G) wireless technology. Finally, we believe Self Storage REITs are well-positioned to benefit from an improving single-family housing market.

Chart 5. 2025 REIT returns mirror 2024 performance but vary widely by sub-sectorsSources: National Association of Real Estate Investment Trusts (Nareit). Data as of September 30, 2025. Returns represent annual total returns for equity REIT sub-sectors, as defined by Nareit. *All Equity REITs = FTSE Nareit All Equity REITs Index. Past performance is no guarantee of future results.

Cash Alternatives and Fixed Income

Equities

Real Assets

Alternative Investments**

Source: Wells Fargo Investment Institute, November 3, 2025.

*Tactical horizon is 6-18 months

**Alternative investments are not appropriate for all investors. They are speculative and involve a high degree of risk that is appropriate only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. Please see end of report for important definitions and disclosures.

Forecasts are not guaranteed and based on certain assumptions and on views of market and economic conditions which are subject to change.

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. Municipal bonds are subject to credit risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Investing in a Business Development Company (BDC) involves economic, credit and liquidity risks in addition to the special risks associated with investing in a portfolio of small and developing or financially trouble businesses. BDCs are exposed to high credit risk amplified through leverage. The use of leverage can magnify any price movements resulting in high volatility and potentially significant loss of principal.Investing in a Business Development Company (BDC) involves economic, credit and liquidity risks in addition to the special risks associated with investing in a portfolio of small and developing or financially trouble businesses. BDCs are exposed to high credit risk amplified through leverage. The use of leverage can magnify any price movements resulting in high volatility and potentially significant loss of principal.

Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is appropriate only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing.

Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.

An index is unmanaged and not available for direct investment.

Cliffwater Direct Lending Index (CDLI) is an asset-weighted index of ~`17,000 directly originated middle market loan holdings totaling ~$425 billion as of December 31, 2024. Reported quarterly, the CDLI seeks to measure the unlevered, gross of fees performance of U.S. middle market corporate loans, as represented by the underlying assets of Business Development Companies (“BDCs”), including both exchange-traded and unlisted BDCs, subject to certain eligibility criteria. The CDLI is asset-weighted and calculated quarterly using financial statements and other information contained in the U.S. Securities and Exchange Commission (“SEC”) filings of all eligible BDCs. The loans captured by the CDLI represent a large share of the direct lending universe and, importantly, represent loans that are originated and held to maximize risk-adjusted returns to shareholders and investors.

FTSE NAREIT All Equity REITs Index, a subset of the All REITs Index, is designed to track the performance of REITs representing equity interests in (as opposed to mortgages on) properties. It represents all tax-qualified REITs with more than 50 percent of total assets in qualifying real estate assets, other than mortgages secured by real property that also meet minimum size and liquidity criteria.

FTSE NAREIT All REITs Index includes all REITs that are listed on NYSE, American Stock Exchange or NASDAQ. This includes mortgage REITs, Timber REITs, Infrastructure REITs, and Manufactured Housing REITs. It is the most expansive of all the FTSE REIT indices.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability or best interest analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. The material contained herein has been prepared from sources and data we believe to be reliable but we make no guarantee to its accuracy or completeness.

Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors.

Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company.

©2025 Wells Fargo Investment Institute and subject to the CC BY-NC-ND 4.0 DEED. All rights reserved. v07.23.25