Despite much hand-wringing of late over what some observers say is the perilous state of the U.S. leveraged loan market, a number of forward indicators suggest the segment might not see a spike in defaults any time soon, even if today's long-running, borrower-friendly credit cycle comes to an abrupt end. That’s according to a new report from S&P Global Markets.
To be sure, the $1.2 trillion market for leveraged loans — increasingly the focus of regulators and lawmakers, amid deteriorating lending terms and rapid growth in the asset class — has benefited from low default rates, especially compared to its counterpart in the leveraged finance market, high-yield bonds.
That remains the case today. At 1% currently, the U.S. leveraged loan default rate is holding near multi-year lows, and is markedly below the 2.93% historical average, according to the S&P/LSTA Index. But even from these most modest levels, several forward indicators suggest that loans have the benefit of time before defaults will materially ramp up.
"Median leverage ratios and interest coverage suggest that if we have a recession today, the leveraged credit sector may have at least a 12-month runway before experiencing high default volume," Kevin Gundersen, head of Guggenheim’s corporate credit group, said in a May report.
Distressed test
There are a number of data points supporting that view.LCD’s analysis of loans quoted at distressed levels (a rising distress ratio is typically a precursor to rising default activity) reveals that just $28 billion of loans in the S&P/LSTA Index are quoted below 80 cents on the dollar.
To put that number in context, if all loans currently quoted in distressed territory were to default today, the default rate of the Index would climb to just 3.66%. Again, the historical average is 2.93%.
The current bid of a debt issue is not necessarily indicative of distress, given that higher recoveries are reflected in the pricing of leveraged loans, compared to bonds, backing a company on the verge of default. Nevertheless, according to LCD, the average bid price of Index loans at the time of default was 58 in 2018, versus just 48 in 2009, during the latter stages of the financial crisis.
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