Used loans have reached a 4-year high

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As they struggle to refinance the wave of cheap loans that followed the Covid-19 pandemic, US companies are paying off loans faster than ever in four years.

Defaults in global credit markets – mostly in the US – rose 7.2 percent in the 12 months to October, as higher interest rates took their toll on heavily indebted businesses, according to Moody’s. This is the highest rate since late 2020.

The rise in companies struggling to repay loans contrasts with a very modest rise in defaults in the high-yield bond market, showing how many riskier borrowers in corporate America have been drawn to the fast-growing credit market.

because of Used loans – Large amounts of bank loans sold to other investors – have floating interest rates, and many companies that took out debt when rates were so low during the pandemic have struggled in recent years with high borrowing costs. Many are now showing symptoms even as the Federal Reserve brings rates down.

“In a low-interest-rate environment, a lot of exits and a lot of stress will take time to come out,” said David Mechlin, credit portfolio manager at UBS Asset Management. “This[default trend]may continue until 2025.”

Penalty loan costs, along with easy covenants, are leading borrowers to look for other ways to extend this debt.

In the US, default rates on junk loans are at a decade high, according to Moody’s data. Expected rates to stay longer – the Federal Reserve Last week it signaled a slowdown in the pace of next year’s rate cuts – likely to continue to put upward pressure on default rates, analysts said.

Most of these defaults involve so-called distressed credit transactions. In such agreements, the terms of the loan are changed and maturities are extended to allow the borrower to escape bankruptcy, but the investors are paid less.

Such deals cover more than half of defaults this year, a historic high, according to Ruth Young, head of private market analysis at S&P Global Ratings. “(Debt swaps) are considered delinquent when they default on the lender,” she said.

“Many of these low-rated debt-only companies will have to restructure their debt by 2024,” Moody’s said in the report.

Portfolio managers worry that these high default rates are the result of changes in the credit market in recent years.

“We’ve had a decade of unprecedented growth in the leveraged credit market,” said Mike Scott, high-yield fund manager at Mann Group. Many of the new borrowers in sectors such as health care and software were relatively light on assets, meaning investors could recoup less of their costs by default, he said.

“The lack of growth and the lack of assets to recover (the lack of growth) was a bad combination,” thinks Justin McGowan, corporate credit partner at Chain Capital.

Despite the high rate of defaults, spreads in the high-yield bond market are historically tight, at least since 2007, according to Ice BofA data, a sign of investors’ appetite for yield.

“We’re pricing where the market is right now,” Scott said.

Still, some fund managers think the rise in default rates will be short-lived because the Fed is now lowering rates. The US central bank cut its benchmark interest rate for the third meeting in a row this month.

Brian Barnhurst, global head of credit research at PGIM, said lower borrowing costs should bring relief to companies that have borrowed in the debt or high-yield bond markets.

“We don’t see defaults in either asset class,” he said. “Frankly, that relationship[between delinquent loans and high-yield bond default rates]will probably break down by the end of 2023.”

But others worry that anxious exchanges signal stress and only put problems off until the next day. “(It’s) nice and good to kick the can down the road,” said Duncan Sankey, Cheney’s head of credit research.

Some analysts blame the loosening of credit limits in loan documents in recent years for allowing an increase in distressed transactions that hurt lenders.

“You can’t put the genie back in the bottle. Weakened (document) quality has changed the landscape in favor of the borrower,” said S&P’s Young.