Direct lending deal volume slowed to a three-year low during the third quarter, as leveraged buyout (LBO) and add-on merger and acquisition (M&A) activity were both weak; at $152 billion year-to-date, volume is running 31% short of 2025’s pace.¹

Additionally, some of the margin expansion within the core and upper middle markets from the first half of 2026 made its way to the lower middle market, where spreads widened by 11 basis points in the quarter. While core and upper middle market spread expansion was likely driven by software exposure—which continued to see the most default activity—we believe the widening of lower middle market spreads reflected a general market correction of the underpriced illiquidity premium for smaller borrowers. Spread per turn of leverage, in contrast, narrowed to its lowest level since August 2025.²

Covenant-lite structures accounted for 17% of direct lending deals through third quarter 2026—up from 14% in 2025—concentrated in the upper middle and large cap markets; cov-lite structures represented less than 3% of deal flow in core and lower middle market loans. Lower middle market default rates over the past 12 months, at 1.8% by dollar amount and 1.5% by deal count, declined since last quarter and remain below 2025 levels.³

Despite the recent rate increase, we anticipate that deal flow could continue to improve through year end, allowing for deployment in an attractive yield environment. We remain focused on selectivity as we evaluate opportunities across industries and subsectors. However, we are skeptical of market lending trends—such as data centers—as we continue to target essential service businesses, which we believe are more insulated from artificial intelligence (AI). We have also pulled back slightly on healthcare given longer hold periods within certain subsectors, and we continue to be cautious on software.

Since the dislocations of Covid-19, we’ve been warning that the next crisis to face the global economy could be sovereign in nature. The selloff in long government bonds worldwide lends credence to this suspicion. In early October, the yield on 10-year US Treasury bonds rose to 5.31%, a 24-year high, from around 4.2% at the start of the year.¹

The price of gold relative to both the stock of public debt outstanding and the S&P 500 stands at or near its geometric mean since 1970, suggesting to us that investors believe the current fiscal backdrop represents a normal level of risk. We don’t share that belief.²

Meanwhile, China’s economy remains very weak and has been increasingly reliant on exports to buoy growth.⁴ With much of its domestic economy struggling, China may need to pull some fiscal levers to stimulate activity at home. At some point the Chinese are going to have to do more on the fiscal front to stimulate their economy, in our view.

In an environment where higher yields are exacerbating fiscal challenges within the biggest macro blocks of the world, we maintain our belief that a diverse collection of scarce, durable assets at sensible valuations is likely to benefit investors in the long run.