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US companies are defaulting on junk loans at the fastest rate in four years, as they struggle to refinance a wave of cheap borrowing that followed the Covid pandemic.
Defaults in the global leveraged loan market – mostly in the US – rose to 7.2 per cent in the 12 months to October, as higher interest rates hit heavily indebted companies, according to a report by Moody's. This is the highest rate since the end of 2020.
The rise in the number of companies struggling to repay loans contrasts with a much more modest rise in defaults in the high-yield bond market, highlighting the number of riskier borrowers in corporate America who have gravitated toward the fast-growing loan market.
because Leveraged loans High-yield bank loans sold to other investors have floating interest rates, and many of those companies that took out debt when interest rates were very low during the pandemic have struggled under high borrowing costs in recent years. Many are now showing signs of pain even as the Federal Reserve cuts interest rates.
“There was a lot of issuance in the low interest rate environment and the rising interest rate pressure needed time to show up,” said David Micklin, credit portfolio manager at UBS Asset Management. “This (hypothetical trend) could continue until 2025.”
Punitive borrowing costs, combined with diluted covenants, are causing borrowers to look for other ways to extend that debt.
In the United States, default rates on junk loans have risen to their highest levels in the past decade, according to Moody's data. Rates likely to stay higher for longer – Federal Reserve Last week signaled a slowdown in the pace of easing next year, which could keep upward pressure on default rates, analysts say.
Many of these defaults involved so-called distressed loan swaps. In such deals, loan terms are changed and maturities extended as a way to enable the borrower to avoid bankruptcy, but investors receive less money.
Such deals account for more than half of defaults this year, a historic high, according to Ruth Young, head of special market analytics at Standard & Poor's, a credit ratings agency. “When (a debt exchange) weakens the lender, it is actually considered a default,” she said.
“A number of low-rated loan-only companies that were unable to tap public or private markets were forced to restructure their debt in 2024, resulting in higher loan default rates than for high-yield bonds,” Moody's wrote in its report.
Portfolio managers are concerned that these high default rates are a result of changes in the leveraged loan market in recent years.
“We have seen a decade of unlimited growth in the leveraged loan market,” said Mike Scott, a senior high-yield fund manager at Man Group. He added that many of the new borrowers in sectors such as healthcare and software had relatively few assets, meaning investors would likely recover a smaller slice of their expenses in the event of a default.
“(There has been) a sinister combination of a lack of growth and a lack of assets needed for recovery,” believes Justin McGowan, corporate credit partner at Chain Capital.
Despite the rise in defaults, spreads in the high-yield bond market are historically narrow, the thinnest since 2007 according to Bank of America data, a sign of investors' appetite for yield.
“Where the market is now, we're pricing aggressively,” Scott said.
However, some fund managers believe the rise in default rates will be short-lived, given that federal interest rates are now lower. The US central bank cut its benchmark interest rate this month for the third meeting in a row.
Brian Barnhorst, global head of credit research at PGIM, said lower borrowing costs should provide relief to companies that have borrowed in the high-yield loan or bond markets.
“We do not see a rise in defaults across either asset class,” he said. “To be honest, this relationship (between leveraged loans and high-yield bond default rates) probably diverged in late 2023.”
But others worry that rocky exchanges indicate underlying stress and only postpone problems for later. “(It's) all well and good to leave the can on the road when that road goes downhill,” said Duncan Sankey, head of credit research at Chain, referring to a time when conditions were more favorable for borrowers.
Some analysts blame the loosening of credit restrictions in loan documents in recent years for allowing an increase in defaulted exchanges that hurt lenders.
“You can't put the genie back in the bottle. Poor quality (documentation) has really changed the landscape in favor of the borrower,” Standard & Poor's Yang said.
