Rachelle Kakouris

While the U.S. leveraged loan default rate hit recent highs, it remains low by historical standards, and the levels of distressed debt in the $1.4 trillion asset class are easing.

The return of net negative ratings actions that intensified among speculative-grade borrowers in the latter half of 2022 has pushed the share of leveraged loan Weakest Links to the highest level in two years. The number of leveraged loan Weakest Links tracked by LCD climbed to 143 issuers, up 24% from September’s tally, and up 49% from June when negative ratings actions began to outpace positive ratings actions.

January’s bankruptcy filings snapped a three-month default-free streak in leveraged loans. The default rate remains well below the 2.7% historical average.

After a brutal 2022, leveraged loan pros expect continued volatility in 2023, with most suggesting that the current credit cycle has yet to reach its low.

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.

Downgrades are of particular interest to CLOs, a huge loan investor segment that has limits on the amount of triple-C rated debt it wants in portfolios.

While defaults in the $1.42 trillion asset class remain scarce, the distressed segment now tops $100 billion, more than five times the amount at the start of 2022.

Leveraged loan holdings at US ETFs and mutual funds fell for a sixth straight month in October. Helped by rebounding prices in the secondary market though, the pace of the decline in asset values last month eased to $3.65 billion, from a $10.62 billion drop in September.

After bankruptcy, recoveries on industries are not created equal. Utilities investors have historically recovered best, while telecom, gaming and real estate have fared worst. Overall, seniority is key.

More than 60% of the $1.44 trillion US leveraged loan market is from private equity-backed issuers, and 90% of all riskier, B-minus rated loans outstanding are via PE sponsors.