A year ago, we argued that rising interest rates and falling profit margins will put firms under pressure and result in rising defaults.1 Leveraged loan defaults have risen since then and we expect further increases over the next 18 months (see Chart 1).
The leveraged loan default rate was 1.71% in July 2023 up from 0.18% in April 2022 but well below the long-term average of 2.71% (orange line). The shaded red area (4% to 6%) is the range of the ZAIS default rate outlook over the next 18 months.2
Source: Pitchbook LCD and ZAIS Group estimates
3
In this issue, we take a closer look at the macro drivers of leveraged loan defaults. In our view, the rise in interest rates and the tightening in bank lending standards are already enough to push the leveraged loan default rate to at least 4% and above the historical average.
From a sector perspective, we view high-tech and healthcare as most vulnerable. We also compare the ZAIS CLO sector and rating allocations with the overall leveraged loan universe.4 We think that our allocations are sufficiently defensive to weather the expected rise in default rates.
Finally, we believe the CLO market will remain robust despite rising default risks in leveraged loans thanks to its structural risk diversification. However, downgrade risks will probably impact CLO performance.
So far, the economy has avoided recession despite the cumulative 525bps of Fed rate hikes since March last year.5 We believe the economy’s resilience reflects positively on its health as well as the strength of the recovery from the COVID crisis. Perhaps a recession can be avoided, but we think that the impact of Fed tightening has not yet fully played out, keeping the economy vulnerable and implying more default risks for leveraged loans.
The circumstances of loan defaults vary case by case. Still, based on our statistical analysis, we have identified three common channels that shape the cyclical swings of the default rate for leveraged loans: interest rates, bank lending standards and profits.
Given the floating rate nature of leveraged loans, the most direct impact of Fed rate hikes to the default rate is via interest expenses. The yield of new leveraged loan issues has jumped from 5% at the start of last year to currently about 10% (see Chart 2), which matches roughly the cumulative amount of Fed rate hikes.
Source: Pitchbook LCD6
The effective interest rate that all issuers pay on their outstanding leveraged loans has increased by about 250bps to around 7% (see Chart 2 again). Although lagged, this is already a significant rise, and we believe it explains much of the rise in the leveraged loan default rate over the last 12 months.
The lagged response of the effective interest rate on outstanding leveraged loans to Fed rate hikes reflects in our view three factors: 1) benchmark floors sitting above the prevailing floating rates when the Fed started to hike rates last year; 2) longer-term (up to one year) structures of the underlying benchmark rates; and 3) more leveraged loan issuers hedging the floating rate exposure than we had thought when the Fed started to hike rates.
However, we think these factors are only delaying the rise in the effective interest rate on outstanding leveraged loans unless short-term interest rates fall again soon and sharply as was the case at the beginning of the COVID crisis (see Chart 2 again).
We expect that the effective interest rates on outstanding leveraged loans will approach the yield of new leveraged loan issues (i.e., 10%) over the next 12 months if the Fed holds interest rates at the current level for longer. Based on our statistical analysis, such a rise in the effective interest rate on outstanding leveraged loans will pressure the interest coverage and lift the leveraged loan default rate all else equal by roughly 1.5% points over the coming 18 months.
It is well recognized that tightening in bank lending standards tends to amplify the impact of rising interest rates – banks become reluctant to lend to borrowers in distress. Typically, the tightening in bank lending standards leads the leveraged loan default rate by four quarters (see Chart 3).
Source: Board of Governors of the Federal Reserve System and Pitchbook LCD7
As a result, we calculate that the tightening in bank lending standards over the last 12 months will add up to 2% points to the leveraged loan default rate over the coming 12 months all else equal. As with Fed rate hikes, something powerful has to happen like the government support packages during the COVID crisis to offset the impact of tighter bank lending standards on leveraged loan defaults.
While we see the path and likely impact of interest rates and bank lending standards as largely set, the direction of profits (EBITDA) appears less clear to us. Economy wide profits and profits of leveraged loan issuers have rebounded strongly with the recovery from the COVID crisis but lost momentum more recently (see Chart 4).
Source: US Bureau of Economic Analysis and Pitchbook LCD8
The risk is that the economy goes into full recession and profits contract by 10% or more. In that scenario, we estimate based on our statistical analysis that the leveraged loan default rate will rise by about 2% points all else equal. However, there is also a chance that profits will reaccelerate, which could lower the leveraged loan default rate by up to 1% point all else equal.
So far, we have looked at the three common channels and their impact on the leveraged loan default rate in isolation. In practice, it is the mix and interplay of the three channels that shapes the outcome. Interest rates and bank lending standards, for example, impact borrowers directly as well as indirectly through their impact on the overall economy.
We think the economy and the financial system are healthy and do not expect a crisis. Thus, a repeat of the default experience during the Great Financial Crisis is unlikely in our view. On the other hand, we believe the default outcome will not be as tame as during the COVID crisis when fiscal and monetary policy were providing unprecedented stimulus support. The Fed has to fight inflation and the outcome of the debt-ceiling negotiations will constrain fiscal policy in the coming years.
Our base scenario is that the Fed will hold rates steady until the end of the year and possibly start easing next year. In our judgment, banks have probably reached the peak in the tightening cycle of lending standards but we do not expect them to ease lending standards before the end of the year. Finally, we think the economy is vulnerable but any recession is unlikely to be deep and profits will probably stay flat, on balance. However, we anticipate more dispersion in profits between weak and strong firms. In that scenario, our calculations suggest that the leveraged loan default rate will move to a range of 4% to 6% over the next 18 months.
There are risks to the upside (more Fed tightening and deeper recession) and there are mitigants to the downside (quick Fed easing and economic rebound). To us, the important message of the analysis is that in our base scenario, which is not all gloom and doom, the leveraged loan default rate is nevertheless expected to make a sizable move upward (from currently 1.7% to at least 4%). In our view, this is primarily the result of the tightening of interest rates and bank lending standards that are already in place but have not yet fully played out.
Looking beyond actual defaults, we expect leverage loan recovery rates to be lower than in the past. Already, while default rates have moved up over the last 12 months, recovery rates have dropped to a historical low (see Chart 5). In our view, the decline in the recovery rate shows that there are more firms with fundamentally failed business models – that only managed to survive in the past thanks to cheap funding conditions – and fewer tangible assets on firms’ balance sheets that can be usefully recycled. We also observe lower recovery rates in loan-only and covenant-lite lending structures.
The orange line is the average recovery rate over the last 25 years (65) and the red bar is the recovery rate over the last 12 months (41).
Source: JPMorgan9
The recovery rate also depends on how quickly economic and financial conditions improve beyond the next 12 months. As we noted before, we are not all gloom and doom. However, we do not anticipate a quick return to easy financial conditions and strong fiscal stimulus. As a result, we think economic growth beyond the next 12 months will be muted and recovery rates are likely to remain in the range of 40% to 50%.
Default risks are dispersed and vary from company to company and between sectors. In our experience, issuers with ratings below B-flat are disproportionally vulnerable to default risks and we view sectors with more than one-third of sub-B-flat rated loans as highly exposed to default risks.10
* Consumer Goods, Services & Transportation; Retail; Beverage, Food & Tobacco
Source: Kanerai CLO Insight11
Currently, nine sectors (High Tech; Consumer Services; Containers, Packaging & Glass; Telecommunications; Healthcare & Pharmaceuticals; Capital Equipment; Automotive; Business Services, Consumer Transportation) accounting for 51.5% of the total universe of outstanding leveraged loans have more than one-third in sub-B-flat rated loans (see Table above). The least exposed with less than 20% in sub-B-flat rated loans are Media, Banking, Finance, Insurance & Real Estate, Aerospace & Defense, Utilities & Electricity, Oil & Gas, Metals & Mining and Hotels Gaming & Leisure.
Whether a sector is more or less vulnerable to default risk is not necessarily a given. In our experience, the sectors with higher default risks are often those that have been expanding rapidly and have seen a large increase in debt issuance, especially from loan-only issuers. Many issuers in High Tech as well as Healthcare & Pharmaceuticals, which are currently the two largest leveraged loan sectors, fall in this category in our view.
The leveraged loan distressed ratio was 6% in June 2023 up from 1% at the end of 2021 and roughly in line with the long-term average (orange line).
Source: Pitchbook LCD12
Distressed ratios have increased over the last 12 months and are currently in line with the long-term average (see Chart 6). If our default rate outlook is correct, however, we think distressed ratios have to rise well above the long-term average, especially in the sectors with high shares of sub-B-flat rated loans.13
At ZAIS, we look at sector fundamentals and their links to the economy. The structure of the leveraged loan portfolio of the ZAIS CLOs, however, is not simply a top-down sector allocation. We follow primarily a bottom-up approach, looking at the fundamentals, risks and return potential of each issuer and loan.
As a result, the sector allocation of the ZAIS CLO leveraged loan portfolio differs from the overall leveraged loan market (see Table above again). In terms of default risks, we believe our portfolio is well positioned to absorb a general rise in default incidences.
Importantly, the ZAIS leveraged loan portfolio has a significantly lower overall share of sub-B-flat rated loans than the market (21.1% versus 35.7%). We have only four sectors (High Tech; Consumer Services; Healthcare & Pharmaceuticals; Automotive) with more than one-third of sub-B-flat rated loans. Our exposure in the nine sectors in which the market has more than one-third of sub-B-flat rated loans is much lower than the overall market (29.1% versus 51.5%).
While the market has the highest concentration in High-Tech and Healthcare & Pharmaceuticals (25.5% of all loans) with on average 56.9% of the loans rated below B-flat, ZAIS has the largest exposure in Chemicals, Plastics & Rubber and Retail (24.5% of all loans) with on average just 22.3% of the loans rated below B-flat.
In contrast to the overall leveraged loan market, we have a larger exposure in what we call the core consumer sectors (Consumer Goods, Services & Transportation; Retail; Beverage, Food & Tobacco, see bottom of Table above). Our share of sub-B-flat rated loans in this group is 24.9% versus 33.0% for the market. Our high exposure to the core consumer sectors reflects our confidence in the individual issuers and loans as well as our view that the consumer sector is generally better positioned to weather a downturn given strong household finances and robust labor market conditions.
Our default rate outlook for leveraged loans, if it materializes, will become a challenge for investors in CLO tranches. We believe that diversification across CLO portfolios, structural protections and reinvestment capabilities reduce CLOs’ own default risk. Indeed, CLOs have a better default track record than comparable leverage loans (see Chart 7). This is particularly evident in the high-yield sectors where the historical default rate of CLOs has been significantly lower than that of corporate debt.15
Source: Pitchbook LCD and JPMorgan16
We believe the main challenge for CLOs will probably come from downgrades that trigger CCC tests. In our view, the B-/B3 CLO buckets are particularly vulnerable to downgrade risks. In terms of issuers, we think the risk is highest with loan-only issuers, which feel the pressure from rising interest rates faster and stronger. For the same reasons, we also expect recovery rates with loan-only issuers to be lower compared to issuers with mixed capital structures.
Finally, we are wary of some new CLO issues with what we view as low excess spreads. If loan defaults pick up, some of these new CLOs may not have enough excess spread to bear the losses compared to older CLOs. How these CLOs will fare will depend on the quality of the underlying loan portfolio.
In our judgment, the best risk-return opportunities are in BB CLO tranches. BB CLOs trade at discount margins between 800bps and 1500bps and well below par values. We believe that the vast majority of BB CLOs are unlikely to experience impairment of cash flows, even under scenarios of significantly higher collateral losses.
As a result, we expect high holding period returns if spreads retrace to historical averages.
However, we see a growing bifurcation between better and weaker BB CLO tranches. The lowest quartile of BB CLOs trade at discount margins of 1200bps or wider and feature portfolios of riskier loans or have lower subordination due to past credit losses. While we think that these securities are unlikely to suffer significant impairments, they are more exposed to deterioration in the ratings and prices of the underlying loan portfolios. As a result, from the perspective of a tranche-buying investor, we are approaching the higher yielding segment of the BB CLO market with caution given the fragility of the current economic backdrop.
As always, we are available to discuss our views with you. Please contact your Client Relations representative at +1 732 978 9722 or zais.clientrelations@zaisgroup.com
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