Unlock Editor's Roundup for free
Roula Khalaf, editor of the FT, picks her favorite stories in this weekly newsletter.
US companies are defaulting on bad loans at the fastest rate in four years as they struggle to refinance a wave of cheap borrowing that followed the Covid pandemic.
Defaults in the global leveraged loan market – most of which is in the US – rose 7.2 percent in the 12 months to October as high interest rates hurt heavily indebted businesses, according to a report from Moody's. This is the highest rate since the end of 2020.
The rise in companies struggling to repay loans contrasts with a much more modest increase in defaults in the high-yield bond market, underscoring how many of corporate America's riskiest borrowers have gravitated to the credit market. with rapid growth.
Because leveraged loans — high-yield bank loans sold to other investors — have floating interest rates, many of those companies that borrowed when rates were extremely low during the pandemic have struggled with high borrowing costs the last few years. Many are now showing signs of pain even as the Federal Reserve cuts rates.
“There was a lot of issuance in the low interest rate environment and high rate stress takes time to play out,” said David Mechlin, credit portfolio manager at UBS Asset Management. “This (default trend) may continue until 2025.”
Punitive borrowing costs, along with easier covenants, are causing borrowers to look for other ways to extend that debt.
In the US, default rates on junk loans have risen to decade highs, according to Moody's data. The prospect of rates staying higher for longer — the Fed last week signaled a slower pace of easing next year — could keep upward pressure on default rates, analysts say.
Many of these defaults have involved so-called distressed credit swaps. In such arrangements, loan terms are changed and maturities are extended as a way to enable a borrower to avoid bankruptcy, but investors are paid less.
Such deals account for more than half of defaults this year, a record high, according to Ruth Yang, head of private market analytics at S&P Global Ratings. “When (a debt swap) hurts the lender, it really counts as a default,” she said.
“A number of lower-rated credit-only companies that could not tap the public or private markets had to restructure their debt in 2024, resulting in higher default rates than those on high-yield bonds. high,” Moody's wrote in its report.
Portfolio managers worry that these higher default rates are the result of changes in the leveraged loan market in recent years.
“We've had a decade of unhedged growth in the leveraged loan market,” said Mike Scott, a senior manager of high yield funds at Man Group. Many of the new borrowers in sectors such as healthcare and software were relatively asset-light, meaning investors were likely to recoup a smaller portion of their outlays in the event of a default. he added.
“(There's been) a wicked combination of a lack of growth and a lack of assets to recover,” said Justin McGowan, corporate credit partner at Cheyne Capital.
Despite rising liabilities, spreads in the high-yield bond market are historically tight, the narrowest since 2007, according to Ice BofA data, a sign of investors' appetite for yield.
“Where the market is right now, we're pricing it in abundance,” Scott said.
However, some fund managers think the jump in default rates will be short-lived, given that Fed rates are now falling. The US central bank cut its key rate this month for the third meeting in a row.
Brian Barnhurst, global head of credit research at PGIM, said lower borrowing costs should bring relief to companies that had borrowed in the debt or high-yield bond markets.
“We don't see an increase in defaults in either asset class,” he said. “To be honest, this relationship (between leveraged loans and high-yield bond default rates) probably changed at the end of 2023.”
But others worry that difficult exchanges hint at underlying stresses and only postpone problems until a later date. “(It's) all good kicking the can down the road when that road goes downhill,” noted Duncan Sankey, head of credit research at Cheyne, referring to when conditions were more favorable for borrowers.
Some analysts blame the easing of credit restrictions on loan documentation in recent years for allowing the rise of distressed swaps that hurt lenders.
“You can't put the genie back in the bottle. The weakened (documentation) quality has really changed the landscape, in favor of the borrower,” S&P's Yang said.
