over 100% since the financial crisis.getty
In this environment of high inflation and uncertainty about the financial health of the banking sector, market participants should carefully review US leveraged finance markets. This asset class, consisting of leveraged loans and high-yield bonds, is very sensitive to rising interest rates and the current uncertainty about the development of the banking sector. In 2022, leveraged loan issuance fell and default rates rose amid rising interest rate pressures. The recent banking turmoil pushed leveraged loan underwriting to its lowest level since 2016.
The leveraged US markets have grown significantly
According to Eric Rosenthal, Senior Director of Leveraged Finance at FitchRatings, “The leveraged loan universe is $1.68 trillion and high yield is $1.33 trillion, also essentially flat from year-end 2022.” This $3 trillion+ market has grown 100% since the 2007-2009 financial crisis. The leveraged loan market alone has grown by about 130%.
An introduction to the US leveraged finance market
Fitch Ratings, 2023.
The majority of leveraged loans are covenant-lite
The technology and healthcare/pharmaceutical sectors are the largest outstanding leveraged loans. About 85% of all leveraged loans are covenant-lite, meaning bondholders have much less protection should issuers default; Some sectors such as construction and materials, chemicals, consumer goods, food, beverage and paper have 90% or more Covenant Lite loans.
Market profile for institutional leveraged loans
The Annual Handbook, FitchRatings
Current leveraged loan default rates are well below their 2009 peak of 10.5%. Currently, the leveraged loan default rate is lower than it was in 2020. As banks begin to reduce lending and funding to increase liquidity, this does not bode well for companies, especially those that are already so leveraged.
Default rate of leveraged loans from US institutions
The Annual Handbook, FitchRatings
It is important to note that rising default rates are not only important for all financial institutions like banks and insurance companies that need to increase their capital to prepare for unexpected losses. They are also important because rising defaults make investors nervous and tend to increase market risk for financial institutions and adversely affect asset prices.
Failure rates are expected to increase.
pitch book
It is important to monitor corporate bond yields as they signal investors’ perceptions of default probabilities and the expected magnitude of losses. Because of the nature of the processes that rating analysts must follow, yields will always evolve much faster than credit ratings. The bailouts of Silicon Valley Bank, Signature Bank and Credit Suisse have widened the spread between corporate and government bond yields, signaling investors’ risk aversion.
Corporate High Yield and US Treasury Spread
Morningstar (FRED data as of March 24, 2023)
Given the current market jitters about banks’ financial health, I am concerned that default rates could rise if banks cut corporate lending. Countless investors such as banks, insurance companies, pension funds, university endowments, hedge funds, asset managers and sovereign wealth funds hold leveraged finance instruments in their portfolios. There is no time like now for investors holding these instruments to ensure they are likely to be hedged to minimize loss of earnings if leveraged finance markets weaken.
More articles by this author
This author has written about 40 articles on leveraged lending and high yield debt; all of her articles are on her Forbes page.
High interest rates will continue to challenge most sectors of the economy
The default volume of leveraged loans in the US has tripled this year
The probability of default increases for high-yield bonds and leveraged loans
The US leveraged finance market is at a record $3 trillion
US companies continue to eat at the debt low
Heavily leveraged zombie companies are threatening the global economy
Impending corporate credit losses are absorbed by financial institutions and even taxpayers
Rising number of zombie companies threatens financial stability
US corporate debt continues to rise, as do troubled leveraged loans
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For over 25 years I have been dedicated to providing quality financial advisory, research and training services on emerging markets, Basel III, risk management, risk-based oversight, capital markets, financial derivatives and Dodd-Frank. I have extensive global expertise and have managed projects in the financial and energy sectors in over 30 countries in English, Russian and Spanish.
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