Key Takeaways
- The leveraged loan default rate could rise to 1.75% by March 2023 from an all-time low of 0.26% in April 2022 as economic growth slows and financial conditions tighten over the next 12 months.
- We expect leveraged loan benchmark rates to reach neutral territory in the third quarter of 2022 and then border on restrictive by the end of the year--up aggressively from near zero when the year began.
Momentum in the credit recovery has continued to carry leveraged loan issuers in 2022, with no defaults in the leveraged loan index since fourth-quarter 2021. The leveraged loan default rate fell to 0.26% in April--matching a record low for the index from December 2007 (see chart 1).
Chart 1
We expect defaults to pick up later this year as the operating environment quickly changes. Economic growth is slowing and leveraged loan benchmark rates are moving sharply higher as the Federal Reserve aggressively tightens monetary policy (see chart 2). With the average floating-rate floor in the index at 44 basis points (bps), issuers' interest expense on floating rate debt could be over 40% higher in just 12 months. This could cause issuer credit quality to deteriorate, and access to capital will be tighter if issuer liquidity becomes constrained.
Chart 2
SOFR could rise another 100 bps in the next two months and another 175 bps by year's end based on fed funds futures. New-issue yields for 'B+/B' rated institutional loans remained neutral in May after spreads tightened in the second quarter. The cost of financing for these loans will likely reach restrictive territory soon, even if spreads remain near current levels.
Chart 3
Tightening financial conditions are already slowing leveraged loan issuance. Following moderate levels of leveraged loan issuance in March and April, issuance in May has disappointed and is the lowest level of monthly leveraged loan issuance since March 2020, when the pandemic froze global markets.
Debt issuance rated 'B-' or lower has stalled after strong leveraged loan issuance in January (see chart 4). As public debt markets tighten, private debt markets may be an increasingly important source of liquidity for borrowers. If debt markets become restrictive over the next 12 months, it could contribute to a rise in defaults.
Chart 4
Nearly 80% of 'B-' or lower leveraged loan issuance year-to-date (through April) was used for mergers and acquisitions (M&A), and this has largely been concentrated in the computers and electronics industry (58%) (see chart 5). This comes after a record surge in M&A related issuance in 2021. The heavy volume of recent M&A could contribute to credit deterioration in the index if the economy sharply decelerates. Leveraged loans used for M&A carry execution risk, and these loans tend to have higher debt multiples with lower interest coverage.
Chart 5
Market volatility has not led to a meaningful rise in distressed loan pricing so far this year. Most industries in the index have low distressed ratios--the percentage of performing loans priced below 80 cents on the dollar.
Distress ratios for the broadcast radio and television, and leisure industries remain high in the index, while the publishing industry distress ratio spiked in April. Issuers in these industries will be affected if consumer and advertising budgets become constrained amid persistently high inflation and slowing growth.
Chart 6
The recovery in issuer credit quality faces a long road, with cumulative net rating actions since January 2020 firmly negative after the high levels of downgrades during 2020 tied to the recession (see chart 7). Monthly net rating actions in the index have been positive since October 2020, and upgrades have trended higher so far this year. However, the pace of upgrades could slow later this year as the economy downshifts.
The hotels/motels/inns and casinos (11), leisure (6), oil and gas (6), electronics/electric (5), and business equipment and services (5) industries have seen the most upgrades year-to-date through April.
Chart 7
The high proportion of issuers rated 'B-' or lower in the index could contribute to a rise in defaults during a downturn. The proportion of the index rated 'B-' or lower became elevated in 2019 before spiking higher in 2020 (see charts 8-9). While the proportion of the index rated 'CCC/C' fell to more moderate levels beginning in 2021, the proportion rated 'B-' remains very high. We expect that a gradual recovery in issuer credit quality will keep the proportion of 'B-' ratings in the index at historically high levels over the next 12 months.
Chart 8
Chart 9
Differences In Default Rate Measurements
The high proportion of selective defaults in the U.S. has kept the broader speculative-grade corporate default rate higher than the leveraged loan index default rate. This is because the definition of default for the leveraged loan index is much narrower.
There are differences in the definitions of default for each default rate series and forecast we analyze in our reports. The S&P Global Ratings definition of default determines the U.S. trailing-12-month speculative-grade corporate default rate.
S&P Global Market Intelligence's Leveraged Commentary & Data's (LCD) definition of default determines the S&P/LSTA leveraged loan index trailing-12-month default rate by number of issuers. This definition of default only includes defaults on loan instruments and excludes selective defaults from distressed debt exchanges. The differences in default definitions are important sources of variation between the two series (see table 1).
Table 1
Table 2
| S&P/LSTA Leveraged Loan Index Issuers By Rating Category Compared To All Speculative-Grade Rated Issuers | ||||||
|---|---|---|---|---|---|---|
| Rating category (%) | All speculative-grade issuers* | S&P/LSTA Leveraged Loan Index rated issuers¶ | ||||
| BB | 27.5 | 20.5 | ||||
| B | 64.2 | 72.9 | ||||
| CCC/C | 8.3 | 5.9 | ||||
| 'B-' Or Lower | 34.3 | 36.1 | ||||
| *Data as of April 30, 2022. ¶The index includes some issuers rated in the 'BBB' category. Data as of April 30, 2022. Sources: S&P Global Market Intelligence's Leveraged Commentary & Data (LCD), S&P Global Market Intelligence's CreditPro®, and S&P Global Ratings Research. | ||||||
How We Determine Our Default Rate Forecasts
The S&P/LSTA leveraged loan index default rate forecasts are based on recent observations and expectations for the path of the U.S. economy and financial markets. Among various factors, we consider our proprietary analytical tool for the S&P/LSTA leveraged loan index issuer base. The main components of the analytical tool are the U.S. trailing-12-month speculative-grade corporate default rate, the ratio of selective defaults to total defaults, a leveraged loan debt-to-EBITDA ratio, the S&P/LSTA leveraged loan index distress ratio, changes to the mix of rated loans toward higher or lower ratings, and the unemployment rate.
Related Research
- Searching For Stress Fractures: Evaluating The Impact Of Interest Rate And EBITDA Stresses On U.S. Speculative-Grade Corporates, May 25, 2022
- U.S. Business Cycle Barometer: Testing The Economy's Resilience, May 20, 2022
- The U.S. Speculative-Grade Corporate Default Rate Could Reach 3% By 2023 As Risks Continue To Increase, May 19, 2022
- U.S. Corporate Credit Quality Remains Insulated From The Russia-Ukraine Conflict…So Far, April 28, 2022
This report does not constitute a rating action.
| Ratings Performance Analytics: | Nick W Kraemer, FRM, New York + 1 (212) 438 1698; nick.kraemer@spglobal.com |
| Jon Palmer, CFA, New York 212 438 1989; jon.palmer@spglobal.com |
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