January 29, 2023

The leveraged loan ‘downgrade wave’ is starting as era of cheap debt fades

A credit downgrade wave has begun to hit the highflying $1.4 trillion U.S. leveraged loan market as the Federal Reserve’s rapid pace of interest rate hikes threatens companies hooked on cheap debt.

Companies that don’t qualify as investment-grade, perhaps because of a large debt load or poor credit history, rushed to take out leveraged loans in the past decade, causing the sector to mushroom to a record size from its post-2008 low of about $480 billion in 2011, according to Refinitiv data.

Now, warning signs of potential stress have emerged as companies with shakier finances navigate a slowing U.S. economy and a higher interest rate world.

Among the first steps has been credit rating firms cutting their initial, rosier assessments of the creditworthiness of companies funded with leveraged loans, even before earnings reflect the toll of the disappearance of easy credit.

“We think the last 10 years aren’t normal,” said Danielle Poli, a co-portfolio manager of the Oaktree Diversified Income Fund, adding that the power is quickly shifting to lenders and away from borrowers as credit conditions have gotten tighter.

Poli pointed to potential blowback in the form of structures that “probably shouldn’t have gotten done” with aggressively adjusted earnings that won’t play out. “At some point, we think weakness among the loan issuer base combined with elevated rates will cause an increase in defaults,” Poli said.

Rush of downgrades

Ratings downgrades in the fourth quarter for leveraged loans were tracking at a 5-year high, above a 5% ratio at S&P Global Ratings and north of 6% at Moody’s Investors Service (see chart), or “one of the weakest quarters outside of the COVID crisis,” according to Morgan Stanley’s leveraged finance strategy team.

A wave of downgrades are hitting leveraged loans


LCD, Bloomberg, Moody’s, Morgan Stanley Research

“The loan downgrade wave has started in earnest and is likely to extend over multiple quarters,” Morgan Stanley’s strategy team led by Joyce Jiang, wrote in a client note Friday, adding that “both agencies have stepped up scrutiny of rates-sensitive balance sheets.”

Leveraged loans are mostly high-yielding, floating-rate debt to companies that may provide extra income for investors as interest rates climb, but also higher default risks when business can’t afford their debt payments.

The loans often are packaged into bonds called collateralized loan obligations (CLOs) and also are held by banks and specialized funds, including exchange-traded funds like the Invesco Senior Loan ETF,
BKLN,

which was up about 2.5% on the year through Tuesday, according to FactSet.

While Poli is cautious on leveraged loans, she still likes the protection of CLO tranches with BB-ratings, given their added credit cushions and “remote loss expectations.” Oaktree and other investment firms like it have become known for distressed debt investing in rough patches in financial markets. 

Related: Apollo says it bought a third of these assets dumped during U.K. financial market turmoil

B, C, D for ‘default’

Leverage loans aren’t for the everyone, and they don’t come with top AAA ratings. About 25% of the U.S. loan market was rated in the BB category as of Dec. 31, with another 62% in the riskier B bracket and less than 6% as CCC and lower category, according to Eaton Vance. The D category represents a default.

While borrowing conditions were strained coming into 2023, analysts at S&P Global said they expect defaults by U.S. speculative grade companies to more than double to 3.75% by next September, in a December outlook. Defaults rose to about 12% in the wake of 2008, according to Fed data.

As was the case with subprime mortgage bubble that spilled over into the 2007-2008 global financial crisis, explosive growth and the end of low interest rates often hit borrowers with the weakest finances the hardest.

Growth in the leveraged loan market accelerated at an average annual rate of 14% since 1997, according to the Federal Reserve’s latest financial stability report, outpacing the 8.4% yearly advance for equities and 6.3% growth rate in residential real estate. The boom can be attributed to a revival of leveraged buyouts, mergers and acquisitions activity, but also to the Fed keeping its policy range near-zero for much of the past decade.

A main worry is that leveraged loan defaults could quickly climb if the outlook for earnings and the economy significantly darkens as the Fed keep up its inflation fight in a tight labor market, particularly with the biggest share of the leveraged loan pie sitting in the riskier B ratings brackets than ever before.

“Revenue momentum will fade, working capital needs remain elevated, and interest
costs continue to rise, meaning that cash flows will start to come under sustained pressure,” said the S&P Global team in their 2023 outlook.

Morgan Stanley strategists went a step further, saying the Fed’s higher policy rates likely will become problematic in the coming months, and that earnings reports may provide not only stocks with a “realty check” but also leveraged loans and the rest of credit markets.

Stocks were mixed Tuesday after two sessions of gains, with the Dow Jones Industrial Average
DJIA,
+0.31%

up about 117 points, or 0.4%, the S&P 500 index
SPX,
-0.07%

was about 0.1% lower and the Nasdaq Composite Index
COMP,
-0.27%

was off 0.3%, according to FactSet.

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