Record Leveraged Loan Deals Mask Emerging Frailty: Credit Weekly

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(Bloomberg) — Debt markets have been in risk mode for weeks, driven by interest rate cuts from the Federal Reserve and the election of Donald Trump to the US presidency. Risk premiums on junk bonds have fallen by more than one percentage point since early August, and companies launched $105 billion in sales of leveraged loans last week, a record.

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However, spreads are priced to perfection, interest rates are still relatively high by the standards of the past 15 years, and some early warning signs for corporate credit are beginning to emerge.

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In November, Chapter 11 bankruptcy filings for businesses rose to the highest level since August 2023, based on borrowers with at least $50 million in liabilities. Meanwhile, the delinquency rate for leveraged loans is at a 46-month high according to JPMorgan Chase & Co., and servicing growth is at its slowest pace in three months.

“We believe the increase in defaults in the loan market is directly attributable to the rising interest rate environment, leaving borrowers with very little margin for error,” said John Broz, managing director and portfolio manager on the Leveraged Credit team at PPM America. “We focus on investing in companies that have a strong market position and pricing power that allows them to withstand higher interest rates.”

Money managers are usually more concerned about the riskier portion of leveraged loans. While assets returned 0.92% in November, the tranche with the riskiest CCC credit rating rose just 0.18%, according to data tracked by Citigroup Inc.

If macroeconomic conditions worsen, rising defaults could push recovery rates near historic lows in most credit markets, according to a recent report from strategists at UBS Group AG, including Matthew Misch.

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“There are clear signs of greater risks in global leveraged loans and private debt,” UBS strategists wrote. Recovery rates for leveraged loans are currently about 13 percentage points below the U.S. average despite low default rates, compared to about 5 percentage points below historical norms for high-yield bonds.

The composition of the market is skewed toward highly indebted companies, many of which are owned by private equity firms that have been hurt by rising borrowing costs after failing to hedge. JPMorgan data shows that about 37% of loan issuers have an interest coverage ratio between one and two, meaning they could struggle to make their payments if the economic backdrop deteriorates.

“The economy is very important for the loan market,” said Nelson Jantzen, a strategist at JP Morgan. “It’s a much weaker mix of issuers.”

Meanwhile, in private credit, collaboration between lenders and private equity has limited defaults for now. However, half of the lower-rated middle market issuers analyzed by Morningstar DBRS received some form of liquidity support such as equity infusions, highly subordinated loans, or deferred principal payments that enabled them to stay afloat.

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To be sure, only about 5% of the leveraged loan market is trading in distressed territory, and strategists expect default rates for this debt to moderate next year. Widely unpopular borrowers have been able to refinance their debt and push back maturities significantly this year.

More problems could occur if borrowing costs fall less than expected due to higher inflation. While most investors expect interest rates to be cut later this month, the path for next year is uncertain due to upcoming policy shifts after Trump’s election, according to a report led by BlackRock’s Amanda Lehman.

For example, Alberto Musallam, president of the Federal Reserve Bank of St. Louis, recently warned that data since September indicate a greater risk that the decline in inflation may reverse.

“Fewer – or slower – Fed rate cuts due to a reacceleration of inflation would be a much less supportive backdrop for risk assets, especially if coupled with weaker growth,” the BlackRock report said.

Week in review

• Wall Street capital markets bankers are poised to get bigger bonuses for their work in 2024. US research firm Options Group expects professionals to receive a 23% increase in total pay compared to 2023. Compensation consultancy Johnson Associates expects an even bigger increase By 25%. 35% increase for bond subscribers.
• BlackRock Inc. agreed. has agreed to buy HPS Investment Partners in an all-stock deal valued at approximately $12 billion, a purchase that will boost the private credit business of the world’s largest asset manager.
• Shimao Group Holdings Ltd. won. A Hong Kong court has decided to reject creditors’ petition to liquidate the troubled Chinese developer, providing more time to complete its debt restructuring plan.
• Atlas SP Partners’ financing unit, Apollo Global Management Inc.’s structured credit business, hit the high-quality market for the first time since receiving its ratings last month.
• Jersey Mike’s plans to sell $850 million in bonds as part of Blackstone Inc’s purchase of a majority stake in the company.
• Tapestry Inc, owner of the Coach and Kate Spade brands, tapped the investment-grade bond market for the first time after it was forced to abandon its acquisition of Capri Holdings Ltd.
• Rakuten Group Inc. sold Global dollar bonds classified as junk amount to $550 million at the lowest cost in more than three years.
• Affirm Holdings Inc., a buy-it-now loan provider, sold a $500 million portfolio of consumer loans to Prudential Financial Inc.’s PGIM Fixed Income.
• Laurentian Bank of Canada is in talks with asset managers including private credit companies to finance about $1 billion in assets for its equipment finance provider, Northpoint Commercial Finance.
• Infrastructure investor Covalis Capital has made a £5 billion ($6.4 billion) bid to take over troubled British water company Thames Water, according to a person familiar with the matter.

On the move

• HPS Investment Partners is offering employees grants over five years to encourage them to stay after its acquisition by BlackRock.
• Royal Bank of Canada has promoted Sian Hurrell to lead its European capital markets business. Hurrell will take over from Dave Thomas, who is retiring after more than 30 years with the bank.
• Societe Generale SA has appointed four senior sales staff in Japan as it seeks to capitalize on the country’s active bond market coupled with local banks’ appetite for high-yield investments.

-With assistance from Rhea Rao and Dan Wilchins.

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