U.S. Leveraged Loan Default Rates Reach New High

The benefits of cheap financing, which many companies capitalized on during the pandemic, are rapidly fading, with risks now becoming increasingly evidentAs the U.Seconomy navigates the aftermath of extensive monetary stimulus, mounting pressure on corporate debt obligations is threatening to destabilize leveraged loan markets and highlight significant vulnerabilities.

According to Moody’s data, the default rate on U.Sleveraged loans reached 7.2% in the 12 months ending in October 2024, the highest level since the end of 2020. Additionally, the default rate on junk-rated loans has surged to the highest point in a decadeWhile the Federal Reserve has started a cycle of rate cuts, analysts indicate that the high cost of financing continues to weaken corporate debt-servicing abilitiesThe challenges in the leveraged loan market are unlikely to ease fundamentally in the near term

"The full impact of high interest rates on businesses has yet to fully materialize," said David Meckling, a portfolio manager at UBS Asset Management"The default trend in leveraged loans could persist well into 2025."

The High Cost of Floating Rates

The leveraged loan market’s boom was driven in part by the low-interest rate environment that prevailed for much of the past decadeFloating-rate loans, which initially offered relatively low costs, became a popular choice for U.ScompaniesHowever, with the Federal Reserve’s aggressive interest rate hikes beginning in 2022, the costs associated with these loans have skyrocketed, significantly increasing the debt burdens on corporations.

This shift has proven especially challenging for industries with lighter asset structures, such as healthcare and softwareThese companies often lack sufficient tangible assets to pledge as collateral, making it more difficult for investors to recover their investments in the event of a default

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This lack of security further exacerbates market risk exposureCheyne Capital’s partner in corporate credit, McGowan, described this phenomenon as a "double whammy of sluggish economic growth and a lack of assets," rendering such firms even more vulnerable in the current high-interest rate environment.

As refinancing pressure mounts in the leveraged loan market, high interest rates are increasingly limiting access to funding through both public and private marketsYang Ruting, head of private market analysis at S&P Global Ratings, noted that companies unable to tap into public or private financing will likely be forced to restructure their debt, which could further drive up default rates.

The Growing Risk of Distressed Loan Exchange

One of the primary drivers behind the surge in defaults has been the widespread use of distressed loan exchangesAccording to S&P Global, more than half of U.S

leveraged loan defaults this year have been tied to such transactionsThese exchanges extend repayment terms or adjust loan conditions to temporarily avoid bankruptcy but come at the cost of sacrificing investor rights.

In recent years, the terms of leveraged loan agreements have gradually loosened, a trend that has been widely recognized as a key factor in exacerbating market risksThis loosening of covenant requirements is seen as a ticking time bomb, accumulating risks within the systemWhile these flexible terms provide borrowers with greater operational latitude, they significantly reduce the protective barriers for lendersThe once-clear lines defining default conditions have become increasingly blurred, making it harder for lenders to spot potential defaults at an early stage.

In the current global financial landscape, the U.Shigh-yield bond market has shown relative stability compared to other more volatile sectors

Data from the Intercontinental Exchange and Bank of America reveals that the spread on U.Shigh-yield bonds has fallen to its lowest level since 2007, a strong indicator of the market's relatively stable performanceDespite mixed opinions within the market, some investors remain optimistic about the long-term effects of rate cutsThey believe that as borrowing costs gradually decrease, businesses will be able to catch their breath.

Brian Barnhurst, head of global credit research at Prudential Fixed Income, noted that the default rate divergence between leveraged loans and high-yield bonds had become evident by the end of 2023, highlighting a significant market performance split.

Accumulating Risks Amid Economic Uncertainty

However, some analysts adopt a more cautious perspectiveThey argue that the frequent use of distressed loan exchanges and the deterioration of borrower asset quality are at the heart of the accumulating risks in the U.S

leveraged loan marketThe market’s structural characteristics make it particularly vulnerable to macroeconomic shifts.

Duncan Sankey, head of credit research at Cheyne, warned, "Delaying problem resolution in the face of steeper future challenges only heightens risk and could ultimately trigger greater market instability."

The leveraged loan market’s complexities present a dual-edged sword: on one hand, it has provided capital to a range of businesses that may have otherwise struggled to secure financingOn the other, the prolonged reliance on such loans, particularly under a rising interest rate environment, has begun to reveal deep-rooted vulnerabilitiesWith the U.Seconomy still reeling from the consequences of rapid rate hikes, corporations are left grappling with the harsh realities of a market that has become far less forgiving.

As the situation unfolds, the focus will likely turn toward corporate restructuring efforts, distressed asset sales, and whether the broader economy can avoid a credit crunch

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