By Daniel Miller, Chief Credit Officer
Synopsis
There are drastically different perceptions of the credit quality of leveraged loan issuers between investors and the rating agencies. Rating agency indicators show that the high interest rate environment, coupled with situational struggles post the pandemic, has led to a huge increase in the Moody’s default measure and also a large increase in the percentage of issuers rated CCC. Yet market measures of credit quality, such as average loan price and some key CLO metrics indicate a healthy
credit profile of leveraged loan issuers.
Both investors and rating agencies are correct. The rating agencies are correctly highlighting alarming increases in leverage for a large subset of issuers. Investors believe that the large volume of restructurings (frequently labeled as LME’s by the market and labeled as defaults by Moody’s) has bought the troubled issuers enough runway (12-24 months) to improve their credit profiles via EBITDA growth and lower SOFR.
Prior to analyzing who’s right, it’s important to understand how the data is changing. Historically, leveraged loan investors could measure historic loss and project future loss by measuring default rate and multiplying it by average recovery ('1 – recovery'). The explosion of LME’s in 2024 have made both metrics almost unmeasurable. One rating agency reports LTM default rate at 1% and the other at 7%. The divergence between the two has eliminated any type of consensus as to what the default rate is. On the flip side, the calculation of recovery is also impaired by the LME’s, which are executed much more quickly than Chapter 11, do not report all details of the restructuring, and sometimes have unequal treatment of creditors in the same creditor class.
Despite investors’ rosier assessment, there is indeed a problem with an historically significant percentage of leveraged loan issuers rated CCC. Without the huge volumes of LME’s in 2024, many of these issuers would have had more serious defaults with material impairments. The LME’s have kicked the can down the road and bought important time for the issuers to take advantage of a lowering of interest rates coupled with an expected uptick in earnings growth. This is our base case scenario, that issuers will benefit enough from earnings growth and rate decreases, to avoid a major default cycle. In a scenario of lower growth rates, similar to the past 21 months (or worse), we can expect to see another spike in defaults. In that case, the likelihood of creditors pursuing another round of LME’s seems unlikely. The more likely outcome would be defaults with more severe impairment because of the additional debt layered on during the 2024 LME’s.
Introduction
The 2022-2023 500 basis point increase in the floating interest rates paid by leveraged loan issuers for outstanding debt has led to a large increase in liability management exercises (“LMEs”) aimed at pushing out maturities, preserving/increasing liquidity, and in some cases outright haircutting debt. A relatively strong average leveraged loan price over the past 12 months indicates that investors believe these restructurings will allow issuers to recover due to future earnings growth and additional expected cuts in the Fed Funds rate. Nevertheless, there is a heavy volume of loan data, namely default rate and ratings data, that point to significant problems on the horizon in the leveraged loan market.
This paper will outline the extent of the problems for leveraged loan issuers, and whether the wave of LMEs and expected rate cuts will be enough to repair the damaged balance sheets of the deteriorated leveraged loan issuers.
The rate cuts themselves will provide overall modest relief to leveraged loan issuers That is because we are forecasting a cut in the Fed Funds rate to 3.5%, not the 0.25% in place prior to the rate hikes. Therefore, for leveraged loan issuers to return to relative health, it will require annual earnings growth rates near 7%, which is well above the modest corporate revenue and EBITDA growth rates observed in 2023-2024[1].
2022 Rates Up White Papers Predicted Increase in Defaults. What Actually Happened?:
In early 2022 Capra Ibex published two white papers examining the impact of the expected rise in Fed Funds rate on leveraged loan default rates. In those papers we argued that the Moody’s default rate would finish well in excess of historic averages. What we did not foresee was the explosion of LME’s (as opposed to more traditional Chapter 11 restructurings), both coercive and constructive, dominating the leveraged loan headlines in 2024. As a result, the Moody’s leveraged loan default rate peaked at 7.1% in Sept-2024, more than two times its long-term average and near its pandemic peak of 7.5% in Sept-2020. Yet, during this same time period of a rising rate environment, we saw the average loan price increase from 92.2 in Sept-2022 to 97.3 in Sept-2024[2]. In addition, the tail risk portions of CLO portfolios have also shrunk (13.8% average CLO loans <85 at Dec-2022 vs 7.0% Sept-2024)[3], all of which points to high investor confidence in the leveraged loan market.
So Which Story is Correct? The Positive Spin
There is significant data (Table 1) supporting a positive view of the leveraged loan market. As mentioned, loan prices are very strong and CLO portfolios have seen persistent decreases in the percentage of loans trading below 85. In addition, Pitchbook’s more traditional definition of loan defaults (only bankruptcies and missed payments) has resulted in an LTM default rate below 1%, which is well below the long-term average of 2.6%[4]. And the percent Defaulted of the broad CLO portfolio has kept below 1% compared to a high of 1.6% in Sept-2020[5]. Lastly, the average Junior Over-Collateralization Cushion in CLO portfolios remains well above the lows of 2020 during the pandemic (2.7 at Sept-2024 vs 2.2 at Sept-2020)[6].
The Negative Spin:
On the flip side, there is a larger quantity of underlying data supporting the argument for cracks in the leveraged loan market. As mentioned above, the Moody’s default rate of 7.1% is more than two times the long-term historic average. The percentage of CLO portfolios with Caa and CCC ratings has increased to 7.7% and 8.9%, respectively, at or near the levels in September-2020[7]. In addition, the average S&P and Moody’s WARFs in CLO portfolios have climbed to alarmingly high levels, also equal to what we saw during the pandemic in 2020, indicating an average rating of B- vs an average rating of B flat at the beginning of the rate hike cycle in 2022[8].
Reconciling the Conflicting Data
There is a clear disconnect between the two sets of data. On the one hand, Moody’s default rate is over 7% and the Moody’s published loan recovery rate is about 60%[9]. That implies annual losses of 2.8%. Yet at the same time, the average CLO Jr OC Cushion has not decreased much at all during the rate hike cycle. There are a few possible reasons to explain why CLO Jr OC Cushions have remained relatively healthy. First, CLOs still in their re-investment periods are able to partially offset credit losses with par-building. Par-building is a common phenomenon and most likely can explain a portion of the offset to credit losses implied by the high default rate. Second, the LME defaults last often just a few days and then are upgraded and treated immediately after as performing credits within the CLO portfolios. Whereas in a traditional Chapter 11, a defaulted issuer will be carried as ‘Defaulted’ for several months in a CLO portfolio; and the restructuring usually involves permanent impairment.
The unique impact of the LME defaults cannot be overstated. The traditional default measure of bankruptcy and payment default is running at less than 1%; and the wider measure, including distressed exchanges is running at 7%. The 6% difference between the two can be explained by the high volumes of distressed exchanges frequently labeled as LME’s. Not all LME’s get labeled as defaults, but many of them do if the rating agencies determine that the creditors received anything less than originally promised. Many of these LME’s have only modest or no haircut to the term loan debt. Instead they negotiate other concessions such as new super senior liquidity facilities, maturity extensions, and payment in kind (“PIK”). While many of these features result in a default rating, these default ratings are immediately cured and the issuer again is classified as performing on CLO trustee reports. This is one of the reasons that the %Defaulted (D rating) buckets in the broad CLO portfolio are so low when compared to the published Moody’s default rate. This also helps explain the wide gap between poor CLO average rating metrics on trustee reports but still the rather healthy levels of Jr OC Cushions.
How/When will CLO Average Loan Issuer Ratings Improve?
Nevertheless, CLOs still have a bit of a hole they need to dig out of. The high volume of LMEs has bought time (typically 12-24 months of liquidity runway) for many of their portfolio issuers. But this wide population of low-rated issuers is still over-leveraged and producing little or negative free cash flow. Therefore, they need relief from two outlets: (1) lower interest expense from lower SOFR; and (2) EBITDA growth. The market’s perceived confidence in both these factors happening, in a nutshell, is the source of the robust market indicators such as the high average loan price and low CLO tail risk. The market fully acknowledges the tough situation of this issuer population. However, there is broad belief that the flurry of LME restructurings has bought enough time to allow for the reduction in SOFR coupled with earnings growth to improve the underlying quality of these leveraged loan portfolios.
In order to determine just how feasible this is, Table 3 takes a look at the credit profile of a sample Company ABC. Pre-2022, with SOFR near zero, a 6x leveraged company had 3.9x interest coverage and free cash flow as a percentage of debt at 10%. This is a profile of a very healthy leveraged loan issuer. Many of these issuers, especially the ones that had to pursue an LME, ended up with increased leverage because of higher interest rates in addition to operational and/or working capital challenges post the pandemic. Fast-forward to today, Sept-2024, sample Company ABC is 9x leveraged with very low 1.2x interest coverage and barely any free cash flow. This profile is pretty typical of the LME issuers in 2024, the ones currently classified as CCC on CLO trustee reports. Looking forward from Sept-2024, Table 3 assumes multiple cuts to the Fed Funds rate over the next 12 months but is forecasting a terminal SOFR rate no lower than 3.5%. It assumes revenue and EBITDA compounded growth equal to the long-term average of public leveraged loan issuers since 2008[10]. Three years of 6.7% growth brings Company ABC closer to its pre-2022 credit profile. So, while the decrease in SOFR will provide some much-needed relief to leverage loan issuers, the key for their recovery lies in earnings growth.
To put that 6.7% average growth rate into context, in 2021-2022 during the pandemic recovery quarterly revenue and EBITDA growth rates averaged 17% and 13%, respectively. However, if we look at 2023 and 2024, revenue and EBITDA growth averaged only 4% and 3%, respectively[11]. For these issuers to grow their way out of their liquidity and leverage problems, they will require growth rates close to 7%, which is near the long-term average since 2008.
Projected Recovery is More Sensitive to EBITDA Growth than Interest Rate Reduction:
Tables 4 and 5 demonstrate that the outlook for these issuers is more sensitive to growth rates than to a reduction in SOFR. Table 4 shows no reduction in SOFR and the same 6.7% growth rate. 2028 leverage in Table 4 is 6.4x, not much more than the 6.1x in Table 3. Table 5 shows a reduction in SOFR to the 3.5% terminal rate and 0% growth. In Table 5, 2028 leverage is a much higher 8.3x, not much lower than today’s 9.0x.
Conclusion
The unprecedented volume of LME’s in 2024 bought time and liquidity for a large segment (mainly CCC) of the CLO leveraged loan population. The LME’s have also bought time for the CLOs as these issuer restructurings kick the can down the road in hopes of improved issuer performance which would improve rating quality in CLO portfolios. In order for this to happen, we would need to see growth levels closer to what we saw in 2021-22 instead of the slower revenue growth rates of 2023-24. Investors, as indicated by robust average loan price and historically low CLO tail risk, believe this will happen. We also believe this to be the most likely scenario. And certainly, the market’s expectation of rollback of government regulation by the incoming administration in the U.S. also supports that outcome.
Nevertheless, it is still too early to understand the extent and impacts of regulatory rollback, not to mention the inevitable micro and macro-economic pitfalls that could accompany a tariff-heavy trade policy. In the case of lower growth and muted rate reductions, we can expect either another round of LME’s or (more likely) a spike in defaults probably as soon as a year from now lasting into 2026. This round of defaults would inflict higher than average impairment because of the debt added on to the troubled issuers during the 2024 LME’s.
Footnotes
[1] Pitchbook US Leveraged Loan Index Credit Stats
[2] Pitchbook US Leveraged Loan Index Daily Spreads
[3] Intex: all CLO deals with more than $200M assets outstanding anytime between June 2019 to Jan 2021
[4] Pitchbook US Leveraged Loan Default Rates (average computed from 1999 to 2024)
[5] Intex: all CLO deals with more than $200M assets outstanding anytime between June 2019 to Jan 2021
[6] Intex: all CLO deals with more than $200M assets outstanding anytime between June 2019 to Jan 2021
[7] Pitchbook US Leveraged Loan Ratings Breakdown
[8] Intex: all CLO deals with more than $200M assets outstanding anytime between June 2019 to Jan 2021
[9] Moody’s Default Trends – Global October 2024 Default Report – Excel Data
[10] Pitchbook Q2 2024 US Leveraged Loan Index Credit Stats
[11] Pitchbook Q2 2024 US Leveraged Loan Index Credit Stats
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