Defaults on leveraged loans soar to highest in 4 years

US companies are defaulting on junk loans at the fastest rate in four years, as they battle to refinance a wave of cheap borrowing that followed the Covid pandemic.

Defaults in the global leveraged financing economy — the bulk of which is in the US — picked up to 7.2 per cent in the 12 months to October, as high gain rates took their toll on heavily indebted businesses, according to a update from Moody’s. That is the highest rate since the complete of 2020.

The rise in companies struggling to repay loans contrasts with a much more modest rise in defaults in the high-gain steady earnings economy, highlighting how many of the riskier borrowers in corporate America have gravitated towards the quick-growing financing economy.

Because leveraged loans — high gain lender loans that have been sold on to other investors — have floating gain rates, many of those companies that took on obligation when rates were ultra low during the pandemic have struggled under high borrowing costs in recent years. Many are now showing signs of pain even as the Federal safety net brings rates back down.

“There was a lot of issuance in the low gain rate surroundings and the high rate stress needed period to surface,” said David Mechlin, financing stake distribution collection manager at UBS property Management. “This [default trend] could continue into 2025.”

Punitive borrowing costs, together with lighter covenants, are leading borrowers to seek other ways to extend this obligation.

In the US, default rates on junk loans have soared to decade highs, according to Moody’s data. The prospect of rates staying higher for longer — the Federal safety net last week signalled a slower pace of easing next year — could keep upward pressure on default rates, declare analysts.

Many of these defaults have involved so-called distressed financing exchanges. In such deals, financing terms are changed and maturities extended as a way of enabling a borrower to avoid financial setback, but investors are paid back less.

Such deals account for more than half of defaults this year, a historical high, according to Ruth Yang, head of private economy analytics at S&P Global Ratings. “When [a debt exchange] impairs the lender it really counts as a default,” she said.

“A number of the lower rated financing-only companies that could not tap community or private markets had to restructure their obligation in 2024, resulting in higher financing default rates than those of high-gain bonds,” Moody’s wrote in its update.

stake distribution collection managers worry that these higher default rates are the outcome of changes in the leveraged financing economy in recent years.

“We’ve had a decade of uncapped growth in the leveraged financing economy,” said Mike Scott, a elder high gain stake distribution manager at Man throng. Many of the recent borrowers in sectors such as healthcare and software were relatively light on assets, meaning that investors were likely to recover a smaller slice of their outlay in the occurrence of a default, he added.

“[There has been] a wicked combination of a lack of growth and a lack of assets to recover,” said Justin McGowan, corporate financing associate at Cheyne stake distribution.

Despite the rise in defaults, spreads in the high-gain steady earnings economy are historically tight, the least since 2007 according to Ice BofA data, in a sign of investors’ appetite for gain.

“Where the economy is now, we are pricing in exuberance,” said Scott.

Still, some stake distribution managers ponder the spike in default rates will be shortlived, given that Fed rates are now falling. The US central lender cut its point of reference rate this month for the third conference in a row.

Brian Barnhurst, global head of financing research at PGIM, said lower borrowing costs should bring relief to companies that had borrowed in the financing or high-gain steady earnings markets.

“We don’t view a pick-up in defaults across either property class,” he said. “To be truthful, that connection [between leveraged loans and high-yield bond default rates] diverged probably in late 2023.”

But others worry that distressed exchanges hint at underlying stresses and only put off problems until a later date. “[It’s] all well and excellent kicking the can down the road when that road goes downhill,” noted Duncan Sankey, head of financing research at Cheyne, referring to when conditions were more favourable for borrowers.

Some analysts blame loosening financing restrictions in financing documentation in recent years for allowing an boost in distressed exchanges that hurt lenders.

“You can’t put the genie back in the bottle. Weakened [documentation] standard has really changed the landscape, in favour of the borrower,” said S&P’s Yang.