Distressed Debt: Opportunities in the Leveraged Loan Market
Back
Article Type
Insights
Topic
Credit
Published
February 14, 2023
Read time
5 mins
Author
Rishi Goel
Share

As rising interest rates and ongoing economic headwinds continue to foster concerns about a possible recession, will the combination create opportunities in the distressed leveraged loan space? Heres what were seeing at the start of 2023, which is shaping up to be an interesting year:

 

Credit fundamentals are weakening, as valuations and multiples continue to contract. Thanks to the relentless rise in rates, interest costs for most issuers have doubled as the LIBOR/SOFR rate has climbed during the past year. That has led to multiple knock-on effects including crimping company cash flows and increasing investor return requirements, which has limited access to primary markets for some borrowers as investors invoke tighter lending standards.

 

Downgrades are outpacing upgrades at a ratio of 2 to 1 and are intensifying. Although only about 7% of the loan market is currently rated CCC or below, more than 50% is rated B or B-, which has resulted in a lower-quality loan index than in past cycles. It is also worth noting that typically 18% of B-rated loans fall to CCC on average, and we believe that rate could be much higher in 2023, particularly since multi-notch downgrades have increased in recent months.According to Barclays, 60% of CLOs could breach the 7.5% CCC bucket utilization threshold as downgrades intensify. 1

 

Defaults are picking up and some market participants are predicting a 5% to 6% default rate in the leveraged loan market in 2023. But even if they just return to the long-term average of 2.5% to 3% similar to our house view, it still results in a significant increase in opportunities. In terms of pricing, as of year end:

  • 21% of the entire loan market trades below $90
  • 8.5% trades below $80
  • 4% trades below $70
  • 2% trades below $602

 

Meanwhile, in the second lien market (which totals approximately $80 billion), 50% of the market is running below $90, 25% below $80, 16% below $70 and 6% below $60.3

  • Unlike the high yield market, the leveraged loan market is up against a maturity wall as close to $200 billion of B- or lower-rated credit matures in the next three years. Specifically, 8% of the leverage loan market matures in 2024 or earlier and 15% matures in 2025.4

 

Given the cloudy economic horizon and the Feds oft-stated commitment to quelling inflation, 2023 may create more bifurcation across the lower-quality market, warranting a disciplined and patient approach, coupled with in-depth credit analysis. While we believe investors should tread cautiously, the year ahead could present attractive entry points and potential once-in-a-cycle opportunities for active managers to capitalize on dislocations within distressed credit. Specifically, distressed credit within the leveraged loan market should be particularly compelling as fundamentals weaken, downgrades and defaults increase, issuers grapple with looming maturities, and CLO holders are forced to deal with their lower-quality credit baskets and holdings.

 

Exhibit 1: Trailing 3-month downgrades in loans and HY are tracking 2019 levels

Exhibit 2: Trends have been weaker for longer in loans

 

Sources for Exhibit 1 and 2: LCD, ICE, Morgan Stanley Research; Note: HY and IG downgrades are based on composite ratings, and loan downgrades on S and P ratings

1Barclays, High Yield and Leveraged Loans-2023 Default Forecast, November 18, 2022.

2J.P. Morgan, US High Yield and Leveraged Loan Strategy, February 3,2023.

3J.P. Morgan, US High Yield and Leveraged Loan Strategy, February 3,2023.

4BofA Global Research, Loans in 2023: A tale of two halves, November 20, 2022

Important disclosures

Author

Rishi Goel
Global Head of Special Situations and Distressed Credit

Rishi Goel is global head of special situations and distressed credit and a senior portfolio manager.

Distressed debt opportunities
Download Article
Distressed debt opportunities
Download Article
Related Articles
View all Aegon insights