Probability of Default Increases for High Yield Bonds and Leveraged Loans

In another sign that the US economy is headed for a hard landing, the probability of default and actual defaults of leveraged loans and high-yield bonds continue to rise. Market signals, along with rating analysts and my research point to a default rate of around 2% or more for 2023-2024.

As I’ve written for nearly a decade, corporate America has been gorging itself in the depths of debt. Until recently, banking regulators in the Comptroller’s Office were keen to state that they would not impose any enforcement action against banks that over-lend to leveraged firms. This regulatory tone, coupled with a low interest rate environment, has also allowed companies to reach historic debt levels.

Today, however, the days of low interest rates have changed dramatically. If there was only inflation in the United States, highly indebted American companies might be able to handle the pressure, but inflation is global. Rate hikes by several key central banks around the world have not been able to eliminate the significant inflationary pressures that have arisen, particularly due to Covid-induced supply chain issues. As a result, US companies face rising prices for many inputs around the world. Additionally, a strengthening dollar means that goods and services from US exporters are increasingly expensive consumers and businesses in many foreign countries.

Eric Rosenthal, senior director of leveraged finance at FitchRatings, explained that “there are a handful of companies that could default in 4Q22 and propel the rate to 2%.” For example, “Ligado Networks LLC, the third largest transmitter in our Bonds of most concern in the market listing, is bidding at a very distressed level.

Fitch US High Yield Default Insight September shows the U.S. high yield default rate over the year (YTD) could climb as high as 1.7% from the current 0.8%, depending on Bausch Health Companies final amount
Inc. (Issuer Default Rating C) Distressed Debt Exchange (DDE). The pharmaceutical company announced anticipated exchange offer results totaling $5.6 billion out of a potential $11.8 billion, which would put the year-to-date default rate at 1, 2%.” If the exchange goes through (closing date is tomorrow September 27), “Bausch’s default would represent the largest since Frontier Communications Inc. in April 2020.”

Diebold Nixdorf Inc., Cooper-Standard Automotive Inc., Ahern Rentals Inc. (which canceled its DDE), Lannett Co. Inc. and Mountain Province Diamonds Inc. are other issuers on FitchRatings. Cheaper list which could be missing before the end of 2022. Rosenthal also stated that “Avaya
Inc. and Bed, Bath & Beyond Inc. are other significant issuers that we expect to default in 2023 but could default sooner.

Currently, Retail, Telecom and Broadcast/Media are likely to lead the default rate in 2023-2024. According to Rosenthal, “the default rate in these sectors is increasing due to very large defaults already anticipated rather than sectoral concerns.” FitchRatings analysts estimate that these sectors could “account for more than half of next year’s default volume, with these sectors reaching rates of around 10%.

Rosenthal also wrote to me that “the high yield bond universe continues to shrink (11e consecutive month) due to both lack of shows and rising stars exiting the market. Emissions were lackluster and contributed to the decline, “with five consecutive months of less than $10 billion in volume. Year-to-date mutual fund outflows of $38.9 billion, coupled with average secondary offering levels at 87.0, hampered market activity.

Investors and regulators should also be concerned that the riskiest loans in the B-rated leveraged loan markets now account for almost a third of the entire market. This is a strong market signal that the probability of default for these companies is increasing. This is the first time there has been such a high level of B loans in the 25-year history of the Morningstar LSTA US Leveraged Loan Index.

Risk managers at financial institutions should not be satisfied with the state of the markets for high yield and leveraged loans. Banks are certainly not immune to the deterioration in the leveraged loan market. Bank of America
CreditSuisse and Goldman Sachs lost more than $500 million in leveraged loan they took out to back Citrix Systems takeover
, the largest leveraged buyout in the United States this year. The loan was sold to investors at a discount of 16%.

Rising interest rates in several countries will negatively affect indebted companies that have floating rate loans or bonds outstanding. London interbank offered rates (LIBOR) are at their highest level since 2008 and other floating rates are also on the rise. This means companies with variable liabilities or that need to refinance this year and next year are vulnerable to higher borrowing costs and possibly default. And sadly, corporate American relief is nowhere in sight.

Note: Rodríguez Valladares has published over 40 articles on leveraged financial markets, corporate debt, and secured loan bonds. They can be found here.

About Evelyn C. Heim

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