What if the safest assets are the true systemic risk? Credit blowups rarely start where we think they will. Investors obsess over defaults because they are visible and scary. Yet the biggest losses in credit come when balance sheets are forced to sell into thin markets. Peter Tchir makes that point. The uncomfortable follow-on is this: the next credit drawdown is more likely to come from a liquidity spiral around supposedly safe paper than from a parade of bankruptcies.
The record is clear. Silicon Valley Bank did not fail because Treasuries defaulted. It failed because mark-to-market losses met flighty funding. During the global financial crisis, structured investment vehicles bought highly rated assets and blew up when haircuts rose and funding pulled back. AIG’s super senior credit positions traded at dirt cheap marks but the losses were paper, not realized. Time and capital repaired them once the liquidation pressure eased. Even in structured credit, investment grade CLO tranches have a better record than the fear suggests. The danger is not credit decay alone. It is credit decay plus leverage plus time pressure. That is the recipe for selling into a vacuum.
Systemic events arrive when a safe asset stops behaving like one. Savings and loan institutions mis-hedged interest rate risk. LTCM levered up basis trades and got margin-called by rising correlations. In both cases, losses were aggravated by the need to sell quickly to meet constraints. Think of a suspension bridge in high wind. The structure holds until resonance takes over and small vibrations become self-reinforcing. In markets, the resonance is the haircut. When dealers and lenders demand more collateral at once, assets designed to be held to maturity must be sold today. The selling moves prices, which triggers more calls, which forces more selling. Defaults arrive later, if at all. The hit to investors comes much earlier.
Rules-based investing adds another layer. Smart beta, volatility targeting, trend strategies, and systematic credit rules move together by design. When the input changes, they all rebalance. The SEC has warned that such rules can produce mechanical herding. High-frequency traders provide liquidity until they do not; then they widen spreads or step away as volatility spikes. The result is a fragile balance. ETFs promise daily liquidity against assets that do not trade daily. In March 2020, bond funds faced mass redemptions, spreads exploded, and net asset values diverged from prices. That was not a wave of defaults. It was a liquidity mismatch laid bare in real time.
Private credit is often described as a new asset class. It looks more like old banking. Club deals, negotiated covenants, and hold-to-maturity intent reduce mark-to-market exposure in good times. In stress, the same features can hide risk or delay recognition. Pretend and extend can buy a company time or dig a deeper hole. The essential fragility is funding. If lenders do not have to sell, the loan can weather a rough patch. If funding disappears, even good loans get dumped. When private vehicles face withdrawals or portfolio companies trip covenants, they first sell what is liquid. That means public high yield, ETFs, and on-the-run bonds. TRACE prints and late-day price marks can tip portfolios into breach. Forced sellers begat more forced sellers. Regulators have pushed liquidity risk programs for funds, but their power against a correlated dash for cash is limited.
In a crisis, the payoff matrix changes. The first seller avoids the worst price. The last holder eats the loss. That prisoner’s dilemma drives rational actors to sell even when the fundamentals have not changed. Authorized participants unwind ETF positions, creating discounts to NAV that signal stress and encourage more exits. Cash investors shorten duration and hoard T-bills. Dealers, constrained by balance sheet limits, cannot warehouse the flow. Collateral haircuts rise and levered basis trades go from safe carry to margin calls. The COVID shock made this plain. The market did not wait for earnings to collapse. It repriced liquidity first. This is not new behavior. It is how modern market structure processes shocks.
Investors underestimate corporate adaptability. RadioShack looked doomed for years before it finally filed. Brunswick slumped into deep junk during the crisis and fought its way back to investment grade. Default cycles take time. Managements cut costs, refinance, sell assets, and pivot product lines. The equity can get wiped out long before the debt fails. Betting on sudden default is often a widowmaker trade. Betting on a liquidity spiral is often a quick one. That distinction matters for portfolio construction. Losses from forced selling can be large, fast, and indiscriminate. Losses from defaults tend to be slower, more idiosyncratic, and recoverable in part through workout.
Start with the assets everyone calls safe. Long-duration paper owned by entities with short-dated funding. Structures that promise daily liquidity against weekly or monthly trading. Strategies that rely on stable correlations and tight spreads to justify leverage. Concentration in rules-based mandates that rebalance on the same signals. High-frequency liquidity that steps back when volatility rises. These are not exotic risks. They are everyday features of the market. When geopolitical and industrial policy shifts realign capital, as with the push for domestic production for security, capital will crowd into favored themes. That does not make them immune. It can even increase fragility if funding becomes one-way and exits narrow.
This is not a call to hide from credit. It is a call to respect plumbing. Assess not just who owes whom, but who funds whom, at what term, under what collateral rules. Watch aggregate leverage and the speed of rebalancing embedded in mandates. Prefer unlevered or long-locked capital when buying carry. Keep dry powder to buy from forced sellers, not from panicked ones. Treat mark-to-market volatility as both a warning and an eventual source of opportunity. Recognize that losses concentrate where investors must meet constraints now, not where risks are highest in theory.
More money is lost in credit from forced selling than from defaults because time is the true risk factor. When the market compresses time, even safe assets cut. When time is allowed to work, even weak credits can muddle through. The job is not to forecast the next defaulter. It is to map the places where many investors share the same stop-loss. That is where credit turns from a yield story into a liquidity story, and where the real drawdowns begin.
