Many companies in the U.S. leveraged loan market, who have taken out floating-rate debt, may encounter significant distress in the coming year if the Federal Reserve maintains its high policy rate, warns Oaktree Capital Management.
Despite appearances of stability, Bruce Karsh, co-chairman and chief investment officer at Oaktree, notes in a recent client note that elevated interest rates are posing challenges for companies to service their floating-rate debt.
Leveraged loans, classified as speculative-grade floating-rate debt, provide borrowers with some flexibility as rates reset only a few times per year. This has protected them from the Federal Reserve’s rate hikes until now.
However, Moody’s Investors Service reveals a worrying statistic – around 62% of companies belonging to the B- ratings category in the U.S. loan market could witness a decline in their ability to pay interest on their debts if the Fed’s policy rate remains unchanged next year (at its current range of 5.25%-5.5%). This would drop their coverage ratio below the key threshold of 1.0x.
Put simply, these companies would end up owing more in interest than they can generate, resulting in defaults unless corrective measures are taken.
It is important to note that speculative-grade ratings, also known as “junk” ratings, range between BB+ and CCC-. These ratings indicate a higher likelihood of default compared to investment-grade ratings, which span from AAA to BBB-.
Leveraged Loan Defaults Hit $25 Billion, Head for Third Worst Year in History, Says Goldman Sachs
Leveraged loan defaults have been on the rise as interest rates reset higher, causing concerns within the financial market. In fact, according to a recent report by Goldman Sachs, leveraged loan defaults have reached a staggering $25 billion, putting the year on track to become the third worst in history for this particular sector.
Despite these alarming numbers, there is no immediate panic among investors. Total returns, as measured by Goldman Sachs, are currently sitting at around 10% for the year. This suggests that market participants are cautiously optimistic and are still finding value in this space.
One exchange-traded fund that has proven popular among investors is the Invesco Senior Loan ETF, ticker symbol BKLN. Year-to-date, this ETF has experienced a modest gain of 2.2%, which is encouraging given the challenging market conditions. Additionally, it offers an attractive dividend yield of 8.47%.
However, it’s important to note that while these numbers may seem favorable now, the situation could change if the Federal Reserve continues to raise interest rates. As time goes on, the grace period provided by the Fed’s rate hikes will likely diminish, exposing leveraged loan borrowers to greater financial pressure.
In fact, according to analysts from Oaktree, a significant portion of the U.S. loan market remains unhedged as of the end of 2021. This means that a substantial portion of the industry is vulnerable to sharp increases in borrowing costs. While they stop short of predicting a “doomsday scenario,” the Oaktree team advises investors to be prepared for potential disruptions in what has been a relatively stable credit market. Despite the warnings, they also highlight that these disruptions may present attractive buying opportunities for those willing to take on more risk.
The impact of these concerns was evident in the stock market on Tuesday. The Dow Jones Industrial Average (DJIA) plummeted around 400 points, equivalent to a 1.2% decline. Likewise, the S&P 500 Index (SPX) and the Nasdaq Composite Index (COMP) experienced losses of 1.5% and 1.6%, respectively. Market sentiment was further influenced by the notable increase in the 10-year Treasury yield since the recent Federal Reserve policy meeting.
As we move forward, it is crucial for investors to closely monitor the leveraged loan market, as the current trend of rising defaults and potential disruptions could have broader implications for the financial industry as a whole. It is important to remain vigilant in order to make informed investment decisions amidst this uncertain landscape.
