The default rate of the U.S. leveraged loan market continues to fall at a rapid pace. At the end of May, the default rate plunged to just 1.73%, down from 2.61% in April, and marking a 244-basis-point decline from the 4.17% cycle peak in September 2020. At 117 bps below the 2.9% historical average, this is also the lowest the default rate has been since the end of 2019, per the S&P/LSTA Leveraged Loan Index. The pace of the decline has accelerated as many of the bankruptcies and missed payments in 2020 have been rolling off the trailing-12-month calculation.
With the Federal Reserve dusting off an already written playbook to implement quantitative easing measures in the aftermath of the 2020 pandemic-era crash, the transition from default cycle to recovery in leveraged loans has unfolded far more quickly than it did following the Great Financial Crisis. Per LCD's data, following the 10.81% November 2009 default peak, the loan default rate did not fall below 1% for 17 months. With $13.4 billion set to roll off the calculation in June and July, and few restructuring candidates in the pipeline, the default rate looks set to dip below 1% by July — just 10 months after the default peak.
The defaulted amount of U.S. leveraged loans over the last 12 months, following three months without any new additions, fell to $20.1 billion in May, down 46% from last year's pace. At the $49.3 billion peak in September, volume was running more than 250% ahead of the corresponding 2019 pace.
Breaking down the sectors, Oil & Gas maintains its dominance in the reading, accounting for 28% of all loan defaults in the 12 months ending in May. Retail follows, at 16%, followed by Leisure and Drugs, both with 9% of defaulted volume.
In a look at how default activity has trended between private and publicly held companies, LCD's data shows that in the most recent periods of elevated defaults — the aftermath of the 2020 crash, and the oil price-driven uptick in 2016 — sponsored companies defaulted at a lower rate than non-sponsored entities. Conversely, away from these periods, sponsored companies generally exhibit higher default activity compared to publicly held companies.
Note that LCD's criteria does not include distressed exchanges, which are more likely to preserve the equity stake held by private equity owners and their control of the company. To that end, a May 11 report by S&P Global Ratings finds that “Selective Defaults” stemming from distressed exchanges among speculative-grade companies have generally trended upward since the Financial Crisis, increasing in 2020 to 45.5% of speculative-grade defaults in 2020, from 28.3% in 2013. The report also finds that out-of-court restructuring has limited efficacy, with 37% of restructured entities during this period either restructuring again or filing for bankruptcy.
Meanwhile, in the same way that central bank support has kept the realized default rate lower than initially feared, distress ratios have remained almost negligible in hovering around 1% since the end of the first quarter. As of the end of May, just 1.1% of performing loans were priced below 80. This compares to a five-year average of 4%, and a March 23, 2020, peak of 57%.
Easing some of the strain around CLO holdings of lower-rated assets, upgrades of leveraged loans are outpacing downgrades at the fastest rate since May 2012, thanks to healthy funding conditions for lower-rated companies and a strengthening U.S. economy that has helped to facilitate the return of favorable ratings actions.
The ratio of upgrades to downgrades of loan facilities in the S&P/LSTA Leveraged Loan Index in the three months through the end of May climbed to 2.14x, marking the fourth consecutive month the rolling count of upgrades has exceeded downgrades.
At the pandemic-driven height, in the three months through May 2020, there were 43 downgrades for every one upgrade.
As would be expected given this current upgrade cycle, the number of loan Weakest Links, as tracked in LCD's recently published Weakest Links analysis, has retreated to pre-pandemic levels at 191 issuers, marking the third consecutive quarterly decline from the pandemic-era peak of 329 in June 2020. While the current reading is higher than year-end 2019 (145 issuers), it is below any quarter in 2020.
As a result, the Weakest Links' share of the market declined to 14% as of March 31, the lowest level since the end of 2019 (11%) and a sharp drop from the 25% peak in June 2020.
At the sector level, by March 2021, some industries returned close to pre-pandemic levels in terms of risky borrower concentration, while others remain elevated relative to December 2019. Only two sectors — Leisure and Clothing/Textile — have expanded the ranks of Weakest Links between the pandemic peak in June 2020 and today.
LCD tracked 22 Leisure names in March 2021, five more than in June 2020 and 19 more than before the onset of COVID-19. This cohort expanded rapidly on the back of downgrades related to social distancing measures during the pandemic. At the end of the first quarter, Leisure took over the leading position in the Weakest Links ranks, displacing Electronics/Electric (LCD's proxy for the technology sector), with 21 names.
Retail and Oil & Gas, two sectors that have dominated the corporate default landscape in recent years, now have fewer Weakest Links than they did at the end of 2019. Most of these borrowers have been on investors' distress radars for a while now and had shifted to the default category last year.
Overall, the count of defaults and restructurings retreated to 35 borrowers as of March 31, below any quarter in 2020 but above the 27 at the end of 2019. This count reached 54 borrowers as of Sept. 30, 2020, the highest reading since the start date of this analysis in 2013.
Looking at the ratings composition of the index as whole, nearly a third of the market is rated B- or lower (by issuer rating). Five years ago, this was just 14% of the index.