Leveraged Loan Defaults Are At Highest Level In Two Years

Year-to-date, leveraged loan defaults stand at close to $23 billion. This level of defaulted debt is higher than the total for all of 2018. Just from October to November 22, 2019, eleven issuers have defaulted to the tune of $7.8 billion. This represents 34% of the total default dollar value this year. Data from Fitch Ratings’ monthly ‘U.S. Leveraged Loan Default Insight’ shows that the trailing twelve month (TTM) default rate ticked up to 1.8%. Leveraged loan analysts at Fitch Ratings expect this default rate to rise to 3% in 2020.

Leveraged loan defaults this year have been from every sector of the economy. The defaults have been particularly acute in the retail and energy sectors. The November TTM default rate in the retail and energy sectors remain higher than the overall market, with both at about 6%. Fitch analysts are forecasting “the year-end 2020 retail and energy default rates at 8% and 13%, respectively.” 

Not only have leveraged loan defaults risen this autumn so have leveraged loans of concern. Fitch’s Top Loans and Tier 2 Loans of Concern have risen in November to $110.1 billion, 3% from October’s $106.8 billion. Loans of Concern represent 8% of the $1.4 trillion U.S. institutional leveraged loan market; in July 2019, Loans of Concern were 5% of the aforementioned market. A Loan of Concern does not necessarily end up in default. However, these loans certainly be monitored. 57% of the November 2018 Top Loans of Concern defaulted (on a par basis) one year later, and 4% of the Tier 2 List did so as well.

35% of the Top Loans of Concern are in the retail and energy sectors. Services, Industrial/Manufacturing, and Healthcare and Pharmaceutical sectors have 35% of Top Loans of Concern. In the Tier Two Loans of Concern, Healthcare and Pharmaceutical leveraged loans account for 25%.

The retail sector has been significantly impacted not only by changes in consumer shopping habits, but also due to private equity firms loading up companies with more debt than they are able to pay back. As I wrote a few weeks ago, there are a number of retail outfits that have distressed credit ratings, so unfortunately, more bankruptcies, not to mention painful layoffs are coming our way.

According to data collected from banks, insurers and asset managers by analytics firm Credit Benchmark, the default risk of companies owned by private-equity firms is 2.5 times that of their public counterparts. According to Eric Rosenthal, Senior Director of Leveraged Finance at Fitch Ratings, of the almost $1.4 trillion broadly syndicated leveraged loan market, private equity sponsors “comprise 67% of the leveraged loan market.”

In their recent report, “Leveraged Loans Insight: Diverging Credit Quality Between Public and Private Equity Owned Firms,” Thomas Aubrey and Sheliza Siddiqui found that “The average probability of default of private equity owned leveraged loan issuers is now 601 Bps [basis points] which corresponds to a consensus rating of b, compared to 236 Bps for publicly listed firms which corresponds to a consensus rating of bb-.”  This means that the credit risk of private equity owned leveraged loan issuers is more than 2.5 times greater than publicly owned issuers. This is equivalent to a 2- notch consensus rating difference. “In addition, private equity owned issuer credit risk has deteriorated by 15% since the low of October 2018; while public companies have only seen a rise in default risk of 6% over the same period.”

A decade of low interest rates, a growing economy, and the rise of non-bank financial institutions, have helped companies reach record level of indebtedness. Unfortunately, as the global economy continues to slow down, downgrades and defaults will rise even more than they have this year.  

Industry advocates tell me not to worry, since the majority of leveraged loans are pooled and sold into collateralized loan obligations (CLO) which include a number of internal and external credit enhancements to mitigate their credit risk. Yet, as leveraged loan downgrades and defaults rise, CLO managers will buy leveraged loans less and less. Whoever ends up holding the leveraged loans will suffer lower recoveries for the defaulted loans, particularly given that 75% of the loans are covenant-lite. Additionally, CLOs are held by a diversity of banks, insurance companies, securities firms, pension funds, and retail funds, all tremendously interconnected to each other; yet the opacity of many of these institutions does not allow us to see where all the credit and market risks of leveraged loans and CLOS ultimately lie.

If it were just the big boys of Wall Street exposed to risk, I would not worry as much. Yet, with rising leveraged loan defaults and rising spreads on CLOs, come painful lay-offs which will hurt ordinary Americans who did not even get invited to the financial institutions and corporate debt-gorging trough party.