Performing Credit Quarterly 3Q2023: Tails, You Lose?

How healthy are today’s leveraged credit markets? If you focus on averages, you’d likely conclude that fundamentals are fairly strong despite elevated interest rates and slowing earnings growth. The average debt-to-EBITDA ratio for U.S. leveraged credit was around 4.0x at the end of the second quarter, down from a high of 6.5x in 4Q2020 and just under 5.0x in 4Q2019.¹ While average interest coverage ratios² have deteriorated over the last year, the current levels – 5.3x for U.S. high yield bonds and 4.5x for U.S. leveraged loans – aren’t sounding alarm bells.³ However, this environment reminds us of one of our co-chairman Howard Marks’s favorite adages, concerning the six-foot-tall man who drowned crossing the stream that was five-feet deep on average.

We believe investors in leveraged credit should be focusing less on average risk and more on tail risk: How is the weakest cohort of the borrower universe positioned? Can these companies service their debt if interest rates remain elevated? When do these companies face debt maturities? What might happen to the value of various debt tranches in a restructuring? When one scrutinizes the weak tails of the leveraged credit markets, it becomes clear that many companies – especially those with outstanding leveraged loans or private debt – borrowed too much at a time when interest rates were near zero, creating capital structures that have become unsustainable now that interest rates have risen by more than 500 basis points.

Importantly, the amount of debt represented by these tails is enormous. Not only have the U.S. leveraged loan (aka broadly syndicated loan) and private credit markets grown roughly twofold and sevenfold, respectively, since the Global Financial Crisis,⁴ but the percentage of lower-quality debt in these markets has also increased.⁵ Loans with credit ratings of B or below represented almost 75% of U.S. leveraged loans at the end of 3Q2023, compared to roughly 35% in 2000.⁶ (See Figure 1.) Additionally, our market observations indicate that private debt experienced a similar deterioration in quality in the decades leading up to the recent interest rate spike.

When the weakest segment of the credit markets is both sizable and more vulnerable than usual, investors face elevated risk that (a) defaults will increase more than expected; (b) average recovery rates will be lower than anticipated; and (c) even healthy companies will experience temporary volatility. If this tail risk becomes a tail reality, both performing and distressed credit investors are likely to encounter an expanded set of pitfalls and opportunities.

Figure 1: Leveraged Loan Quality Has Declined as the Market Has Grown

Source: Preqin, Pitchbook LCD, JP Morgan; Credit Suisse Leveraged Loan Index

A Tail of Two Markets

When analyzing the U.S. leveraged credit markets, it’s important to first acknowledge the significant difference in quality between high yield bonds and leveraged loans. Almost half of the high yield bond market is now rated BB (the highest rung of below-investment-grade credit), which is near a ten-year peak.⁷ While BB-rated debt represented more than 30% of the leveraged loan market ten years ago, that figure has since fallen to just above 20%, and B-rated debt now accounts for approximately 65% of the market.⁸ This reduction in quality has only worsened over the last year, as the ratio of downgrades to upgrades in the loan market has risen to nearly two to one.⁹ We believe downgrades will almost certainly increase for weaker B-rated loans if borrowers’ earnings strength continues to weaken as their interest expense remains elevated. Finally, while broadly syndicated loans have slightly lower average leverage than high yield bonds, that’s not the case with private debt. CreditSights estimates that median net leverage among private loans was almost twice that of high yield bonds at the end of 1Q2023.¹⁰

This divergence is driven primarily by two key factors: (1) loans became the financing tool of choice for leveraged buyouts (especially those involving highly leveraged healthcare and technology companies) in the years leading up to the interest rate spike in 2022 and (2) loans, unlike bonds, are predominately floating-rate instruments. We estimate that roughly two-thirds of outstanding U.S. leveraged loans were unhedged as of YE2021.¹¹ As a result, loan-only borrowers, which now represent the majority of the U.S. loan market, have seen a roughly 50% increase in interest expense over the last year, compared to only 21% and 3%, respectively, for bond-and-loan and bond-only issuers.¹²

When honing in on tail risk, the difference in quality between these asset classes becomes even more marked. Tail risk has increased moderately in the high yield bond market over the last year. The percentage of issuers with both interest coverage ratios below 1.5x and cash-to-debt ratios below 10% climbed to a post-GFC high in 2Q2023.¹³ But the risk in the public and private loan markets is far more pronounced:

• Slim interest coverage ratios: Moody’s Investors Services looked at the impact that a federal funds rate of 5.25%-5.50% would have on the interest coverage ratios¹⁴ of more than 300 companies in the U.S and Canada with credit ratings of B3 (the equivalent of B- at other rating agencies). They projected that, when accounting for capital expenditures, the interest coverage ratios of 62% of these companies would fall below one by the end of 2023.¹⁵ (See Figure 2.) This deterioration would primarily be driven by spiking interest costs, though slowing EBITDA growth would likely also play a role.

Figure 2: Interest Coverage Ratios in the U.S. Loan Market Could Decline Meaningfully

Source: Moody’s Investor Services, as of July 27, 2023, forecasts as of July 2023

• Worrisome maturity profiles: While many issuers in both the bond and loan markets were able to refinance debt in recent years and thus extend their maturities, refinancings were less common among lower-rated borrowers. (See Figure 3.) Leveraged loans rated B3 and lower now represent the majority of 2024 maturities.¹⁶ Private loans are facing an even more troubling near-term outlook. Almost 40% of the direct lending market is scheduled to mature by year-end 2025, compared to roughly 15% of broadly syndicated loans, according to Bank of America.¹⁷

Figure 3: Low-Rated Loans Haven’t Materially Improved Their Maturity Profiles

Source: Pitchbook LCD, Bloomberg, Morgan Stanley Research, as of September 15, 2023; issuer rating by S&P Global

Importantly, we believe these overleveraged, interest-rate-sensitive borrowers could find themselves struggling to service their debt whether the Federal Reserve sticks a hard or soft landing. A recession would obviously further impair many vulnerable companies’ fundamentals, but so would a sustained period of elevated interest rates, the likely outcome if there isn’t a near-term recession. As we wrote in Performing Credit Quarterly 2Q2023: Fighting the Fed:

… recession or no recession, we think the probability of higher-for-longer interest rates is far greater than the likelihood of near-term cuts. Therefore, we believe leveraged finance markets are likely to experience higher default rates going forward even if the economy avoids a recession.

Thinking Big

How should credit investors respond in this environment? First, they should recognize that what most distinguishes this environment from those in the past is the sheer size of the global universe of potential dislocated debt. It has quadrupled since the GFC.¹⁸ U.S. markets have grown so significantly that even if the annual default rates for U.S. leveraged loans and high yield bonds were to remain below their recessionary averages and only increase to their normal long-term averages for a three-year period, the resulting total would exceed the three-year default volume recorded during either the GFC or the dot-com crash in the early 2000s.¹⁹ This would both dramatically expand the universe for distressed debt investors and give skilled performing credit managers the opportunity to distinguish themselves through their superior risk control.

In short, we may increasingly discover which credit investors have been able to – as we like to say at Oaktree – avoid the losers. These investors will likely have fewer problems in their legacy portfolios and thus be in a good position to take advantage of the bargain-hunting opportunities that may increase in the coming quarters. Meanwhile, less prudent investors may – like that six-foot-tall man – find themselves struggling to deal with an unexpectedly sharp drop.

Credit Markets: Key Insights for 4Q2023

What trends, risks, or opportunities are Oaktree experts focused on today? Below are key insights that we believe investors should keep in mind when navigating today’s markets.

(1) Limiting duration and taking credit risk has benefited investors in 2023 and may continue to do so – if it’s smart credit risk

In the first three quarters of 2023, credit spreads have narrowed, while Treasury yields continued to rise. Thus, debt investors who kept duration short by accepting some credit risk typically outperformed those who bet on an imminent recession by meaningfully increasing their sensitivity to interest rate increases. (Oaktree discussed this dynamic in a recent podcast.) Consider that U.S. investment grade bonds lost 1.2% in the first three quarters of the year, while U.S. high yield bonds and leveraged loans – which both have much shorter duration than IG debt – returned roughly 6.0% and 10.0%, respectively.²⁰ Clearly, most investors have been better off if they’ve avoided making large bets on macroeconomic forecasts and instead simply taken advantage of the high yields on offer.

However, in a highly uncertain environment in which companies’ ability to service or refinance their debt is likely to become more challenging, it’s essential that investors engage in rigorous bottom-up analysis and risk control. By doing so, they can potentially reduce the likelihood that they’ll surrender return through defaults and be better able to build a portfolio that can perform well regardless of the twists and turns of the economic cycle.

(2) Technical factors are increasingly benefiting the high yield bond market

We’ve long noted that technical factors (i.e., factors unrelated to issuers’ fundamentals) have helped support prices in the leveraged loan market, but we’re now seeing a similar trend in the high yield bond market. While demand for the latter has been negatively impacted by the spike in interest rates since YE2021, supply has also been declining over this period. In the last two years, the par value of outstanding high yield bonds fell from $1.6 trillion to $1.2 trillion in the U.S. and from $692 billion to $490 billion in Europe.²¹

This contraction partly reflects the aforementioned increase in interest rates, as rising yields have caused many companies to refinance existing debt via alternative instruments (e.g., convertible bonds) or avoid issuing new debt. Additionally, in the last year, fallen angels (i.e., bonds downgraded from investment grade to below-investment grade) have been outpaced by bonds whose credit ratings have moved in the opposite direction. Finally, many of the weakest companies defaulted during the pandemic and have been unable to reissue. While interest rate volatility could weigh on all fixed-rate assets in the coming months, we believe positive technicals, moderate duration, and high quality will continue to provide counterbalancing support for the high yield bond market.

(3) In private credit, risk is concentrated in legacy portfolios, not recent deals

When assessing risk in private credit, it’s important to recognize that quality varies meaningfully by vintage. Private credit deals completed in the last year have typically had fairly strong fundamentals: Senior leverage has been only 3.5x on average; the average equity contribution from sponsors has grown to roughly 60%; and the average yield spread has widened by 100-150 bps since YE2021.²²

Risk is therefore concentrated in deals put in place before 2022 – when base rates were near zero, earnings estimates were optimistic, and investor protections were typically nonexistent. Specifically, we believe the weakest 20 to 30% of private credit portfolios have a meaningful risk of experiencing defaults or write-downs in the near term. Indications of rising stress are already present, as publicly traded business development companies (BDCs), which hold private debt, have begun to announce that some of their underlying borrowers are having to amend loan terms or engage in other actions associated with credit deterioration.

We believe private creditors are less likely to face these legacy portfolio issues if they limited their participation in LBOs during the boom period and instead focused on non-sponsor-backed deals with companies that needed capital for less speculative activities, like strategic growth initiatives. Private creditors that refrained from reaching for yield when interest rates were near zero may now be well positioned to secure both high yields and downside protection.

(4) The opportunity in CLO equity has historically been superior in dislocated markets

Many investors say “you make money on your buy” and, historically, this has been the case for those investing in CLO equity. We conducted back-testing using an approximation of an average new CLO portfolio, which indicated that the strongest performance for equity investors is likely to occur during periods in which a majority of loans are trading below par.²³

Even though it may be more expensive to finance a CLO in a dislocated market, once the market strengthens, managers can typically refinance their liabilities at much narrower yield spreads. Managers obviously don’t have a similar opportunity to reprice their assets once markets recover.

If CLO managers have done their credit work and sought to limit the risk of default and, more importantly, the risk of loss, then the discounted portfolio should recover to par over time. And because of the leverage inherent in CLO equity, that movement back to par has the potential to generate a very attractive total return. But, of course, such performance is only possible if managers avoid (or limit) defaults and losses, which is why we believe credit expertise, experience over multiple cycles, and risk control are essential for successful CLO managers.

(5) The risk/return calculus for credit versus equity investment may be shifting

We’ll give Howard the last word, with an excerpt from his recent memo Further Thoughts on Sea Change:

• Will asset ownership be as profitable in the years ahead as in the 2009-21 period? Will leverage add as much to returns if interest rates don’t decline over time or if the cost of borrowing isn’t much below the expected rate of return on the assets purchased? Whatever the intrinsic merits of asset ownership and levered investment, one would think the benefits will be reduced in the years ahead. And merely riding positive trends by buying and levering may no longer be sufficient to produce success. In the new environment, earning exceptional returns will likely once again require skill in making bargain purchases and, in control strategies, adding value to the assets owned.… Lending, credit, or fixed income investing should be correspondingly better off.