Cushions built up during the economic recovery continue to support U.S. leveraged loan issuers rated by S&P Global Ratings, with just two defaults in the Morningstar LSTA US Leveraged Loan Index in the second quarter. The leveraged loan default rate rose slightly to 0.43% in June and remained at that level in July. We expect defaults will pick up later this year as difficult operating conditions take hold. In our base forecast, 24 issuers default in the 12-month period ending June 2023, and the default rate rises to 2.0% (see chart 1).

Chart 1

Issuers contending with tighter margins from higher costs and supply-chain constraints now also carry much higher interest expense (see charts 2 and 3). In less than eight months, the three-month LIBOR rose 275 basis points (bps) as the Federal Reserve aggressively tightened monetary policy, and rates are expected to rise another 75 bps to 100 bps by year-end. This will increasingly constrain cash flow, with the extent of credit deterioration largely dependent on the degree to which growth in issuers' operating income slows.

Chart 2

Chart 3

S&P Global Ratings economists expect a low-growth (growth below potential) recession in 2023, and their qualitative assessment of recession risk over the next 12 months is currently 45% (within a wider range of 40%-50%). If issuer operating income were to sharply slow such that balance-sheet liquidity became constrained, access to capital would likely be restricted. We expect this would lead to an increase in issuer defaults through June 2023 (see chart 4).

Chart 4

Cushioning The Slowdown's Impact

While economic growth has slowed, corporate earnings reported for the second quarter appear resilient so far, after consumers continued to spend despite pressure on budgets from 40-year-high inflation. But the test of consumer resilience is just beginning. The impact of cumulative rate hikes and wealth effects will continue to weigh on sentiment, and consumer spending through the first half of the year was buffered by healthy household savings. Fewer job opportunities, eroded purchasing power, and asset price returns in the red will likely continue to constrain discretionary spending.

Coming off a period of extraordinarily easy financial conditions and robust economic growth, issuers have also built up cushions, and this should soften the impact of the slowdown. Issuers took advantage of favorable market conditions during 2020 and 2021 to push out debt maturities and lower the cost of capital. At the end of the second quarter, median interest coverage for a sample of issuers in the leveraged loan index stood at an all-time high, and median leverage remained near its lowest level since fourth-quarter 2018. This supports our view that even though defaults will quickly rise through June 2023, the default rate will remain below the long-term average of 2.5% (see charts 5 and 6).

Chart 5

Chart 6

Optimism Based On Resilience, Not A Fed Pivot

The marginal pressure from increased input costs and higher interest expense tends to contribute to a higher default rate outside of recessionary periods (see chart 7). Even with a soft landing for the U.S. economy, the cumulative effect of higher rates would likely contribute to an uptick in defaults. In our optimistic case, we forecast the default rate will rise to 1%.

Chart 7

Markets appear to be anticipating this soft landing, with risk assets rallying broadly beginning in mid-June on optimistic expectations that front-loaded rate hikes from the Federal Reserve would bring inflation under control (see chart 8). This gave way to expectations for less monetary tightening and for a quicker pivot back toward the neutral rate in late 2023.

Chart 8

Amid signs that inflation has dropped from its July peak, with economic weakness yet to show up in the labor market and with consumers so far continuing to spend, expectations for a short and shallow recession, rather than a marked contraction, are warranted. But in this context, we believe the fed funds rate will remain well above neutral in 2023. With slack in the labor market yet to form and inflation far above its 2% target, the Fed is unlikely to ease off the brakes anytime soon (see chart 9). Resilience in issuer credit quality, not easy money, is what will keep the default rate low in 2023.

Chart 9

Restrictive Primary Markets

The cost of financing for new-issue 'B+'/'B' institutional loans surged to restrictive levels in June, and the total spread surpassed 750 bps, its widest level since fourth-quarter 2011, in July. The total spread has tightened modestly in August but remains over 700 bps.

Meanwhile, yields for these loans breached 930 bps in July and remain near that level in August. Even in an optimistic scenario where the total spread sharply tightens back to 450 bps, the cost of financing for these loans would remain restrictive based on current benchmark rates--and leveraged loan benchmark rates are expected to rise another 75 bps to 100 bps in the next four months.

Chart 10

The tightening of financial conditions has stalled speculative-grade ('BB+' or lower) debt issuance this year, and debt issuance rated 'B-' or lower has nearly ground to a halt. Public debt markets will likely remain restrictive, and private debt markets could be an increasingly important source of liquidity for borrowers.

In our pessimistic case, a marked downturn would continue to suppress credit market activity across the board, limiting funding and exit strategies for distressed borrowers. Larger corporate borrowers, in particular, may have even fewer alternatives, given the private markets have less liquidity, at $5 billion or more. If borrowers struggle to access bridge financing, and with slower credit markets potentially suppressing distressed mergers and acquisitions (M&A), we forecast the default rate could rise to 4.25% by June 2023.

Chart 11

Where We See Downside Risk

Over 80% of 'B-' or lower leveraged loan issuance year to date (through Aug. 18) went toward M&A (see chart 12), concentrated in the computers and electronics industry (50%). This comes after a record surge in M&A-related issuance in 2021. The heavy volume of recent M&A activity 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 12

More generally, the high proportion of issuers rated 'B-' or lower in the index could also contribute to a sharper rise in defaults. The proportion of the index rated 'B-' or lower became elevated in 2019 before spiking higher in 2020 (see chart 13). While the proportion of the index rated 'CCC'/'C' fell to more moderate levels beginning in 2021, the proportion rated 'B-' remains very high at 31%.

We would generally expect to see downgrades from 'B-' to 'CCC'/'C' pick up ahead of default activity. Over the past two months, the negative bias (the proportion of issuer ratings with negative outlooks or CreditWatch implications) for all 'B-' issuers rated by S&P Global Ratings has begun to rise. However, at 9% in July, it remained well below its long-term average of 35%.

Chart 13

Downgrades have modestly increased in the past three months (see chart 14). Monthly net rating actions (upgrades minus downgrades) in the index turned negative in May for the first time since September 2020. Even so, downgrades in the index remained historically low.

The health care (nine), electronics/electric (eight), containers and glass products (seven), business equipment and services (four), food products (four), home furnishings (four), and telecommunications (four) industries had the most downgrades year to date through June.

Chart 14

Already there is evidence of higher interest expense pressuring cash flow for some highly leveraged issuers in high technology and health care. The electronics/electric and health care industries account for 34% of issuers in the leveraged loan index rated 'B-' or lower.

Meanwhile, some consumer products and retail/restaurants issuers are reporting weak operating results. We expect inflation, supply-chain disruptions, and less favorable macroeconomic conditions to weigh on issuer credit quality. Persistent inflation and supply-chain disruptions are also pressuring credit quality for some issuers in the capital goods and automotive sectors.

We anticipate weaker macroeconomic conditions will strain credit quality for some media and entertainment issuers, especially those exposed to advertising spending. Broadcast radio advertising, for example, already shows signs of a slowdown. There is divergence in the sector, though, as some issuers' credit quality remains underpinned by improved fundamentals and normalizing social activity following the extreme effects of mandatory business closures and mass social distancing.

Chart 15

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.

Leveraged Commentary and Data's (LCD's) definition of default determines the Morningstar LSTA US 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

How We Determine Our Default Rate Forecasts

The Morningstar LSTA US Leveraged Loan Index default rate forecasts are based on recent observations and expectations for the path of the U.S. economy and financial markets. We consider, among various factors, our proprietary analytical tool for the Morningstar LSTA US 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 Morningstar LSTA US Leveraged Loan Index distress ratio, changes in the distribution of higher- and lower-rated loans, and the unemployment rate.

Related Research

• The U.S. Speculative-Grade Corporate Default Rate Could Reach 3.5% By June 2023, Aug. 18, 2022
• U.S. Real-Time Data: Prices Are Cooling On Weakening Demand, Aug. 12, 2022
• Leveraged Loan Market Could Feel The Pinch Of Higher Benchmark Rates And Risk Premiums For A While, Aug. 10, 2022
• U.S. Recession--Are We There Yet?, Aug. 2, 2022
• U.S. Leveraged Finance Q2 2022 Update: Corporate Borrowers Brace For Slow-Growth Recession, July 27, 2022