Record Leveraged Loan Deals Mask Emerging Frailty: Credit Weekly

(Bloomberg) -- Debt markets have been in risk-on mode for weeks now, fired up by Federal Reserve rate cuts and the election of Donald Trump to the US presidency. Risk premiums on junk bonds have plunged more than 1 percentage point since early August, and companies launched the sales of around $105 billion of leveraged loans this past week, a record. 

Still, spreads are priced for perfection, interest-rates are still relatively high by the standards of the last 15 years, and some early warning signs for corporate credit are emerging.

In November, Chapter 11 bankruptcy filings for companies surged to the highest since August 2023, based on borrowers with at least $50 million of liabilities. Meanwhile, the default rate for leveraged loans reached a 46-month high according to JPMorgan Chase & Co., and services growth is running at the slowest pace in three months. 

“We believe the increase in defaults in the loan market is directly attributable to the high interest-rate environment, leaving borrowers with very little margin for error,” said John Broz, managing director and portfolio manager on the leveraged credit team at PPM America, Inc. “We focus on investing in companies that have strong market position and pricing power that will allow them to endure high rates.”

Money managers are generally more concerned about the riskier portion of leveraged loans. While the assets returned 0.92% in November, the riskier CCC rated slice gained only 0.18%, according to data tracked by Citigroup Inc.

If macroeconomic conditions do worsen, higher defaults could push recovery rates near historical lows across most credit markets, according to a recent report by UBS Group AG strategists including Matthew Mish. 

“There are clear signs of greater riskiness in global leveraged loans and private debt,” the UBS strategists wrote. Leveraged loan recovery rates are currently running about 13 percentage points below average in the US despite low default rates, compared with just 5 percentage points below historical norms for high yield bonds.

The composition of the market is weighted toward more indebted companies, many of them owned by private equity firms who have been hit by higher borrowing costs after failing to hedge. About 37% of loan issuers have an interest coverage ratio between one and two, JPMorgan data show, meaning they could struggle to make their payments if the economic backdrop deteriorates. 

“The economy is so critical to the loan market,” said Nelson Jantzen, a strategist at JPMorgan. “It’s a much weaker issuer mix.”

In private credit, meanwhile, cooperation between lenders and private equity has limited payment defaults for now. Still, half of the lower-rated middle market issuers analyzed by Morningstar DBRS have received some form of liquidity support such as equity injections, deeply subordinated loans or deferred principal payments that enabled them to stay afloat.

To be sure, only about 5% of the leveraged loan market is trading in distressed territory and strategists expect default rates for that debt to moderate next year. Junk borrowers have broadly been able to refinance their debt and push out maturities significantly this year.

More trouble could come if borrowing costs fall less than expected because of a pickup in inflation. While most investors expect an interest rate cut later this month, next year’s path is uncertain because of upcoming policy shifts following the election of Trump, according to a report led by Amanda Lyman at BlackRock Inc. 

For example, St. Louis Fed President Alberto Musalem recently cautioned that data released since September suggest a greater risk that the decline in the rate of inflation could reverse.

“Fewer – or slower – Fed rate cuts because of re-accelerating inflation would be a much less supportive backdrop for risk assets, especially if coupled with weaker growth,” the BlackRock report said.

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--With assistance from Rheaa Rao and Dan Wilchins.

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