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Defaults in the $1.4tn US junk loan market have climbed sharply this year as the Federal Reserve’s aggressive campaign of interest rate rises increases the pressure on risky companies with “floating” borrowing costs.
There were 18 debt defaults in the US loan market between January 1 and the end of May totalling $21bn — greater in number and total value than for the whole of 2021 and 2022 combined, according to a Goldman Sachs analysis of data from PitchBook LCD.
May alone saw three defaults totalling $7.8bn — the highest monthly dollar amount since the depths of the Covid-19 crisis three years ago.
The failures underscore the pressure being exerted on lowly rated companies with large debt piles as they bear the brunt of the US central bank’s tighter monetary policy to curb high inflation.
“There is a payment shock unfolding among the weakest issuers in the loan market,” said Lotfi Karoui, chief credit strategist at Goldman Sachs.
Many “junk”-rated companies loaded up on leveraged loans — debt with floating borrowing costs that move with prevailing interest rates — when the Fed slashed rates close to zero at the peak of the Covid crisis. Issuance nearly doubled between 2019 and 2021 to $615bn, data from PitchBook LCD shows.
However, the Fed has lifted its “target range” for interest rates to 5 per cent to 5.25 per cent in just over 14 months. That has left borrowers facing much higher interest payments, just as slowing economic growth threatens to squeeze earnings.
This combination is “really problematic for companies that have a big chunk of their liabilities in floating-rate form”, added Karoui.
Among the companies to have defaulted this year for the first time, as classified by rating agency Moody’s, are cinema advertising group National CineMedia and infrastructure services provider QualTek. Some companies that defaulted in 2023 had already previously defaulted, such as Envision Healthcare and mattress company Serta Simmons.
Many companies that are rated junk now rely on leveraged loans as a critical source of financing — the asset class has swelled to roughly the same size as the junk bond market.
Bank analysts and rating agencies expect defaults to rise further as market expectations shift to interest rates staying higher for longer and as the lagging effects of successive rate rises are felt.
The threat is overshadowing investors holding particularly risky debt in a scenario that threatens to fuel even more downgrades, restructurings and bankruptcies as borrowers struggle to access fresh funding.
“We are lining up here for a pretty meaningful default cycle,” said Steve Caprio, head of European and US credit strategy at Deutsche Bank.
Loan issuance fell sharply in 2022 and has been meagre this year because most companies do not urgently need cash, after replenishing their coffers and pushing out maturities while money was cheap.
Compounding the situation, the biggest buyers of leveraged loans — known as “collateralised loan obligations” — are unable to hold large amounts of very risky debt because of safety mechanisms in their own capital structures. They have a typical cap of 7.5 per cent of their assets for “triple-C” rated loans.
If more companies have their credit ratings downgraded to triple-C, it could trigger a process that cuts off cash flows to the lowest rung of investors in the CLO structure in order to redirect money to investors higher up the CLO ladder.
There is still demand for lower-quality single-B loans, said Drew Sweeney, a loan portfolio manager at asset manager TCW, referring to the rating just above triple-C. But investors “have to have some faith that those are not going to be the most likely loans to be downgraded”.
Market estimates of defaults are rising, although forecasts vary depending on the breadth of loans, definitions of default and different economic forecasts.
For the 12 months to May 2023, the loan default rate stood at 1.58 per cent, according to LCD — up from 1.31 per cent in April and the highest figure since May 2021.
Karoui pointed out that were relatively few defaults in 2021-2022, so the market could simply be reverting “back to normal”.
But loan defaults are still rising at a faster pace than defaults in their corporate bond counterparts, which have fixed coupons and therefore are slower to feel the effect of Fed policy changes.
According to a Goldman’s analysis of Moody’s data, the annualised default rate for US junk bonds in the three months to April 30 stood at 3 per cent — flat since February and up only slightly from 2 per cent a year earlier. In contrast, the same measure of defaults for loans reached 6 per cent in April, up from 2 per cent a year earlier.
On top of interest rate pressures, “the credit quality of the loan space is poorer than the bond space”, noted John McClain, a portfolio manager at Brandywine Global Investors.
Rating agency S&P believes that the 12-month trailing loan default rate could rise to its long-term average of 2.5 per cent by next March, up from 1.42 per cent in April 2023. But in a pessimistic scenario, the number of “stressed borrowers” could surge and credit challenges persist — meaning “many issuers cannot access capital”.
TCW’s Sweeney said that some companies with strong prospects will still find willing lenders.
Private equity firms, which back many loan issuers, are “not going to walk away from a capital investment when they think it could be worth much more — and so that they contribute a certain amount of capital, and then go through the process of an amend and extend”, he said.
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