With no payment misses or bankruptcies among companies in the Morningstar LSTA US Leveraged Loan Index in the fourth quarter of 2022, the institutional loan default rate closed the year at 0.72% by dollar amount.
In remaining near recent lows and well below the historical average, this lagging indicator masks a rising undercurrent of troubled companies within the index, as the volume of loans priced at distressed levels and the count of negative downgrades have been rising.
By issuer count, the default rate was also nearly unchanged in December, at 0.68%. This is up from a record low of 0.26% in April.
LCD’s criteria excludes distressed exchanges.
Moving into 2023, as noted in LCD’s Quarterly Leveraged Finance Survey, tougher financial conditions will, at best, require that companies pay more to raise or refinance debt. For the less solvent, prohibitive funding costs or a shunning of risk will heighten focus on the implications of ratings downgrades and credit losses. To that end, the share of loans backing companies now trading at distressed levels — and thereby implying limited access to par market funding — increased significantly in the second half of 2022.
Per LCD data, the distressed cohort of performing index loans, defined as loans trading below 80% of par, is now nearly eight times higher than at the beginning of the year, at $103 billion. Though for context, during the height of the pandemic market crash in March 2020, this cohort skyrocketed to $672 billion.
Currently 7.4% of performing loans in the index are priced below this measure for distress.
Amid concerns that the high concentration of B3 and B-minus rated loans could inflate CCC buckets in CLOs in an event of a downgrade wave, activity picked up again in December, with downgrades outpacing upgrades by a ratio of 2.77x, the fastest rate since the default peak of September 2020.
Among the more pressing situations to garner downgrades of index loan facilities in December, Avaya Holdings Corp. disclosed in a regulatory filing that it has been engaging with lenders around a potential debt restructuring, either out-of-court or in-court via Chapter 11.
“We think Avaya, lacking alternative options to strengthen its balance sheet, is very likely to pursue a debt restructuring, which we consider tantamount to, or filing for, bankruptcy protection,” S&P Global Ratings said in a Dec. 16 report. The ratings agency downgraded both the company and its senior secured debt to CC, from CCC-.
The telecommunications and software vendor, which previously filed for bankruptcy in 2017, has three term loans in the Morningstar LSTA US Leveraged Loan Index totaling $1.89 billion.
Also on LCD’s shadow default watch, S&P Global Ratings on Dec. 9 downgraded Equinox Holdings and its issue-level ratings to CCC-, from CCC, citing its belief that a default or distressed debt restructuring appears highly likely to occur within six months without a significantly favorable change in the company’s circumstances. Equinox has a $76 million revolving credit facility that is coming due in March 2023. Additionally, the remainder of the company’s first-lien senior secured term loans are coming due in March 2024.
In looking at loans needing to be repaid, just $82.4 billion of the $1.41 trillion in outstanding loans, per the Morningstar LSTA US Leveraged Loan Index, mature in 2024 or earlier.
However, 57% of this total, or $47.2 billion, is from issuers rated B-minus or lower.
Looking ahead, while the pain of mass defaults is not expected to be a trouble spot for some time yet, the rapid shift in market conditions and the macro-economic environment has investors bracing for a fast ascent from the current lows where loan default rates are concerned, per LCD’s quarterly Leveraged Finance Survey.
In this survey, given between Dec. 1 and Dec. 9, LCD asked market professionals where they expect the US loan default rate (by amount) to be at the end of 2023.
LCD’s polling shows a median expectation that the loan default rate (as measured by the Morningstar LSTA US Leveraged Loan Index) will finish 2023 between 2% and 2.49%.
This compares to a default rate of 0.73% at the end of November, just before polling commenced.
In an option for comment in the quarterly survey, one buyside analyst noted that “downgrades and triple-C bucket implications [with respect to CLOs] will be more consequential than actual defaults.”
While the landscape for credit defaults is back on the radar, respondents expect defaults to be kept in check in 2023 since some of the excesses were flushed out in the 2020 default cycle. More importantly, respondents cite the heady pace of refinancings in 2021 and early 2022 that pushed out debt maturities and provided a stronger starting point for corporates to service their debt in the face of a slowing economy.
The overriding feedback from survey respondents on the topic of defaults is that the covenant-lite structure will (artificially) keep default rates low, though it’s the length of any default wave, rather than the spike, that would be of greater concern.
LCD’s polling shows 61% of market professionals expect the default rate of leveraged loans to reach the historical average of 2.73% (by amount) by the end of 2024. Some 30% said this would happen between 2025 and 2026.
“Leveraged loan documentation structure has been tightening but it is significantly weaker than historical average,” opined a buyside investor participating in LCD’s survey outreach. “That is why we are below historical default rates. The true metric to track will be the loan recovery rate, which is expected to be lower due to weaker lender protections.”
Among Wall Street predictions, Morgan Stanley’s base case is leveraged loan defaults at 2.5-3.0%. Barclays forecasts both leveraged loans and high-yield reaching default rates of 5-6%. The firm believes that, following the debt market house-cleaning of the hyper-liquid pandemic, “the remaining universe is fundamentally in better shape and should help limit the extent of defaults in the near term.”
S&P Global Ratings, which measures off the Morningstar LSTA US Leveraged Loan Index, believes the default rate could rise to 2.5% by September 2023 in its base case, according to a report published on Dec. 7.
With all that said, LCD looked at the data to see how much in terms of defaulted volume (excluding distressed exchanges) it would take to match previous default rate peaks.
To reach the trailing twelve-month default peak of 4.17% during the 2020 pandemic, this would require $56 billion of index defaults in the current market size. To hit the all-time high default rate of 10.81% seen in 2009, $145 billion of leveraged loans would need to default.
Featured image by winyuu/Shutterstock
Learn more about our editorial standards.
