For the first time this year, the US leveraged loan market in September recorded a month free from defaults among constituents of the Morningstar LSTA US Leveraged Loan Index, though default rates are expected to resume trending higher over the next year, as per LCD’s US Leveraged Finance Survey.
In tandem with easing stress barometers more generally, and with four facilities rolling off the trailing 12-month calculation, the loan default rate by amount fell to 1.27% at the end of September, a nearly 50 bps reduction from the end of July.
The default rate by issuer count, at 1.67%, though down from 1.86% in August and 2% in July, remains above its 10-year average of 1.58%.
With the slowing default activity, and facilities rolling off the calculation, the lagging twelve-month volume of loan defaults fell to $18 billion, the lowest since February.
Non-sponsored companies continue to exhibit higher default rates than their sponsored counterparts, though the differential narrowed in September. The loan default rate for sponsored companies in September was 1.31%, versus 2.22% for non-sponsored. Note that LCD’s criteria does not include distressed exchanges, which are more likely to preserve the equity stake held by private equity owners and their control of the company, in large part explaining this trend.
Looking at stress signals, the share of performing loans priced below 80 — a line in the sand for the loan distress ratio and demonstrated forerunner for the future default rate — eased to 4.36% in September, from 5.21% in August and 5.46% at the end of July.
This translates to $60.7 billion of loans currently priced at distresses trading levels. Though down from a 32-month high of $103.43 billion at the end of December, note that $18.09 billion of this decline is from defaulted loans leaving the performing calculation in 2023.
Turning to rating trends, the rolling three-month ratio of downgrades to upgrades eased to 1.73x, a 15-month low, from 1.79x in August and as high as 3.32x in February.
Finally, though stress indicators are improving, and credit conditions are easing, borrowing costs will remain high in this elevated rate environment for companies that did not, or could not, hedge. As such, market pros generally expect an above-average rate of defaults a year from now, with the narrative calling less for a dramatic spike, but rather a rate that is elevated for longer.
As mentioned previously, LCD conducted its quarterly US Leveraged Finance Survey in mid-to-late September. Once again, we asked a roster of buyside, sellside and advisory accounts where they think the default rate will be one year from now. Their 12-month forward forecast for leveraged loan defaults was unchanged from the second-quarter survey, at 2.50–2.99%. At the 2.75% midpoint, this would push the loan default rate slightly above its 2.70% historical average.
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