Ten months after hitting a cycle peak of 4.17% in September, the default rate of the S&P/LSTA Leveraged Loan Index fell to just 0.58% in July. This is the lowest it has been since April 2012, according to LCD data.
Thanks to markets that are now awash with liquidity following the implementation of the Federal Reserve’s crisis-stemming quantitative easing measures, the transition from default cycle to benign credit cycle in leveraged loans has occurred at a swift pace. Per LCD's data, following the 10.81% November 2009 default peak, the loan default rate did not fall below 1% for 17 months, compared to ten months this time around.
By LCD's measure, which does not include distressed exchanges, the leveraged loan market has remained default-free for five straight months. By issuer count, the rate stands at 0.88%, its lowest since October 2015.
The big question is how long this environment of ultra-low default rates will last. By way of background, a stretch of sub-1% defaults following the financial crisis lasted for 13 months, but the market was sporting significantly better ratings, and companies were issuing with less leverage back then.
Ultra-low default rates following a restructuring wave is a typical cycle phenomenon given that the bad balance sheets are flushed from the markets and, therefore, overall credit quality is expected to improve. But with the Fed acting quickly to roll out its already established monetary policy tools during the 2020 pandemic crash, the share of companies rated B- or lower — largely the result of record issuance from this ratings bracket — is unchanged from the default peak.
Only 1% of performing loans in the index were priced below the distressed threshold of 80 cents on the dollar at the end of July, and just 2.74% of loans in the $1.3 trillion asset class were below the stress marker of 90.
Despite rising fears that a third wave of COVID-19 cases could be on its way in the U.S. and globally, two industries inextricably tied to the reopening of the economy — Retail and Leisure — have sector-level distress ratios of just 1.78% and 1.35%, respectively.
The backdrop for defaults and market stress levels may well be benign, but the ratings quality mix shows no improvement from the default high in September, with nearly a third (31%) of leveraged loan issuers rated B- or lower. This compares to 32% at the September default peak.
Looking further back, when the loan default rate dipped below 1% in April 2011, only 19% of issuers carried a corporate credit rating of B- or lower, compared to 24% during the November 2009 default peak.
In tandem, the average debt multiple of large corporate loans in the new-issue market at the end of the second quarter was 5.5x, according to LCD. In 2011, it was just 4.4x.
A final word on ratings: 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 July slowed to 2.25x, from 2.28x in June, which marked the highest ratio of upgrades to downgrades since June 2011.