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US companies are defaulting on junk loans at the fastest rate in four years, as they struggle to repay cheap loans that followed the Covid pandemic.
Defaults in the mortgage market – most of them in the US – rose to 7.2 percent in the 12 months to October, as higher interest rates take risks from heavily indebted businesses, according to a report from Moody's. That's the highest rate since late 2020.
The rise in companies struggling to repay loans contrasts with a modest rise in defaults in the high-yield bond market, highlighting how many U.S. corporate borrowers have been drawn to the fast-growing mortgage market.
Because common loan – high-yield bank loans sold to other investors – with floating interest rates, many of those companies that took on debt when rates were so low during the pandemic have struggled under high borrowing costs in recent years. Many are now showing signs of pain as the Federal Reserve brings rates down.
“There was a lot of issuance in a low interest rate environment and high rate pressures need time to exit,” said David Mechlin, credit portfolio manager at UBS Asset Management. “This (sustainable situation) could continue until 2025.”
Penalty borrowing costs, and easy covenants, lead borrowers to look for other ways to extend this loan.
In the US, default rates on junk loans rose to a decade high, according to Moody's data. The prospect of rates staying high for a long time – i Federal Reserve last week showed a slow rate of reduction in the next year – it can maintain high pressure on fixed rates, say analysts.
Many of these failures involved so-called poor credit. In such deals, the terms of the loan are changed and the maturity is extended as a way to make the borrower avoid bankruptcy, but the investors are paid less.
Such transactions accounted for more than half of defaults this year, a historic high, according to Ruth Yang, head of private market analysis at S&P Global Ratings. “When (a debt transaction) disrupts the lender it actually counts as a default,” he said.
“The number of companies with only low-cost loans unable to sell on the public or private markets has had to restructure their debt by 2024, leading to higher default rates for loans than for high-yield bonds,” Moody's wrote in its report.
Portfolio managers are concerned that these high default rates are a result of changes in the mortgage market in recent years.
“We've had a decade of unrealized growth in the mortgage market,” said Mike Scott, senior high yield fund manager at Man Group. Most of the new borrowers in sectors like health care and software were asset-light, meaning investors could recoup a small chunk of their spending in the event of a default, he added.
“(There's been) a bad combination of a lack of growth and a lack of asset recovery,” opines Justin McGowan, credit partner at Cheyne Capital.
Despite the increase in defaults, the spread in the high-yield bond market is historically tight, at least since 2007 according to Ice BofA data, a sign of investment interest in yield.
“Where the market is right now, we're pricing with excitement,” Scott said.
However, some fund managers think that the spike in default rates will be short-lived, as Fed rates are now falling. The US central bank cut its benchmark rate this month for the third meeting in a row.
Brian Barnhurst, global head of credit research at PGIM, said lower borrowing costs should bring relief to companies that have borrowed money or in high-yield bond markets.
“We don't see a default pick for any type of asset,” he said. “Honestly, that relationship (between subsidized loans and high mortgage rates) breaks down probably as late as 2023.”
But others worry that a tense exchange reflects underlying stress and puts off problems until the next day. “(It's) good to kick the can down the road when that road goes down,” said Duncan Sankey, head of credit research at Cheyne, referring to when conditions were more favorable for borrowers.
Some analysts blame the loosening of credit restrictions on loan documents in recent years for allowing an increase in distressed transactions that have hurt lenders.
“You can't put the genie back in the bottle. “Weak quality (documentation) has changed the landscape, in favor of the borrower,” said S&P's Yang.