(Bloomberg) -- JPMorgan Chase & Co.’s Nelson Jantzen has a calming notion for investors alarmed by the US corporate default rate rising to almost 6% by one calculation. 

About half the volume of corporate debt included in the default rate in one measurement isn’t wholly a problem for investors, at least not now. In another analysis, the speculative-grade default rate is actually closer to about 3% at the end of March, according to Jantzen, a head of US high yield and leveraged loan strategy.

The difference stems from what happens when a company tries to avoid bankruptcy by entering a distressed debt exchange. Such a swap can result in all of a company’s debt counting as having defaulted according to an issuer-weighted metric widely used in the industry.

But a distressed debt exchange may not translate to a company failing to make all its interest payments. In a par-weighted measure, debt used in a distressed exchange is included but only the amount that was actually swapped.

“A lot of the confusion is around the absolute numbers being reported because people aren’t necessarily feeling it to that effect in their portfolio,” Jantzen said in a telephone interview.

Distressed debt exchanges are becoming popular as a way for troubled companies to preserve the value of their bonds and loans by extending maturities on specific obligations, usually with the holders agreeing to take a haircut, or reduced price. While such swaps still represent events of default, investors are betting on a better return than if the borrower tried another workout route, such as filing for bankruptcy. 

More than 50% of the default volume in the first quarter included a distressed debt exchange, compared to around 30% in 2023, according to JPMorgan data. 

Moody’s Method

At Moody’s Ratings, the company that for more than a century has set creditworthiness standards on Wall Street, analysts say the US default rate hit 5.8% at the end of March, a level not seen since 2021.

That’s an issuer-weighted calculation, which includes the likelihood that bond and loan covenants will spur accelerated payments on all debt when an issuer defaults. This approach counts a distressed exchange as equivalent to a bankruptcy or default.

“Our default rate will be a little more elevated,” said Julia Chursin, vice president of the corporate finance group at Moody’s. “But if you exclude distressed exchanges, you are omitting a large chunk of the market.”

The gap in the default rate shown by the two methodologies is the highest on record, according to JPMorgan. Some portfolio managers say they’ve had to explain why to investors. 

“That’s a pretty material difference,” said Joe Lynch, global head of non-investment grade credit at Neuberger Berman. “There are a lot of implications for how investors look at these metrics.”

S&P Global Ratings estimates the first-quarter default rate at 4.8%, while Fitch Ratings reports separate metrics by volume and by count for high-yield bonds and leveraged loans. Moody’s also reports a par-weighted default rate but only for high-yield bonds. 

Investor Preference

Most investors tend to prefer par-weighted calculations because they reflect real losses on returns, rather than the number of companies that had a default, according to Michael Best, portfolio manager at Barings. 

“You can have small bad companies default for any number of reasons,” he said. “If you have a name that’s held by everybody default, that matters more to investors in larger corporate fixed income.”

To be sure, any one measurement of the rate at which companies are defaulting will offer an incomplete picture of corporate stress. The rise of distressed debt exchanges has also come with more companies defaulting multiple times and ultimately filing for bankruptcy, even after restructuring their debt at least once.

And that also means diminishing recoveries, especially when those distressed debt exchanges pit lenders against each other. A benign default rate could still translate to more losses for lenders if recoveries plunge.   

“You’re seeing different recoveries in the same lender class,” said Samantha Milner, a partner and US liquid credit portfolio manager at Ares Management. “So how do you avoid or minimize the defaults, and then maximize the recoveries?”

Whichever methodology investors embrace in assessing the overall risk of more defaults, Moody’s has what may be welcome news. The ratings firm expects their calculation of the default rate peaked in the first quarter and will moderate to the mean of around 4.7% by June. 

Taking note of the par-weighted metric, JPMorgan in a note on Tuesday said that “default rates on HY bonds and loans remain low despite two years of increasingly restrictive Fed policy.”

Even an anticipated delay of a few months by the central bank in cutting rates “is unlikely to materially change the trend in corporate credit metrics,” JPMorgan said.

©2024 Bloomberg L.P.