A blemish-free July has kept the default rate of the S&P/LSTA Leveraged Loan Index close to record lows, though distress levels, as a forward indicator, suggest the market will soon move away from this ultra-benign environment for payment misses and bankruptcies.
With no companies rolling off the trailing twelve-month calculation, the default rate by amount was unchanged from June, at 0.28%.
The default rate has edged higher from a pandemic-era low of 0.18% in April, but remains well below its historical average of 2.75%.
By issuer count, the default rate closed July at 0.43%. This is up from a record low of 0.26% in April.
LCD’s criteria excludes distressed exchanges.
Distress doubles down
Looking ahead, healthy coverage ratios, a dearth of immediate maturities and few pressing restructuring situations in the loan index point to a below-average default rate as the base-case scenario in the year ahead. However, tightening financial conditions amid inflationary pressure and concerns of an impending recession have prompted a significant uptick in the volume of performing loans priced below 80 — a forward-looking measure of potential future defaults.
Per LCD’s data, the "below 80" cohort of the loan index has roughly doubled in the past six months, to $41.76 billion.
Loans priced below 90 cents on the dollar — indicating both idiosyncratic risk and broader market stress — eased in July after jumping significantly in June. According to LCD, the below-90 cohort stood at 12.7% as of July 31, down from 16.2% on June 30, but still elevated from 7.61% in May and 2.97% in April.
A key change in sentiment is also evidenced in ratings trends, where downgrades outpaced upgrades for a second consecutive month, after June brought an end to a 16-month upgrade cycle for the asset class. On a rolling three-month basis, the downgrade count of loan facilities in the S&P/LSTA Leveraged Loan Index exceeded upgrades by 1.74x in July, up from 1.3x in June.
While CLO managers — the largest buying base for leveraged loans — might seek to offset this by sourcing higher-rated assets, in the secondary market LCD data continues to show a downward migration of ratings quality in the $1.4 trillion S&P/LSTA Leveraged Loan Index. The share of issuers in the index with a B-minus rating, at 28.3%, is nearly equal to the share of issuers in the index with a B flat rating, at 28.6%.
Assuaging the shifting sentiment, loan maturities across the index are limited over the next several years. As of July 31, the volume of loans coming due in 2024 or earlier dwindled to just $125 billion. At the end of 2020, that number was closer to $400 billion. 