P-p-p-pressure in leveraged loans

Steven Abrahams | January 10, 2025

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The leveraged loan market has always seemed like the most likely place to see credit stress first. The balance sheets are, well, leveraged, and heavy reliance on floating-rate debt has left the borrowers with much higher interest expense after the Fed’s tightening. Fed easing always dangled the promise of relief, but that is now delayed if not deferred. Stress, however, is starting to show—not in traditional default statistics, but in ways entirely new and less predictable. For some loan investors, it could hurt.

Traditional payment defaults among loans included in the Morningstar/LSTA Leveraged Loan Index, the market’s main benchmark, have run at 1.45% by count cumulatively over the last 12 months (Exhibit 1). That pace is relatively normal, comparable to the one before Covid hit in 2020 (Exhibit 1). Defaults alone might leave the impression that these heavily indebted balance sheets have survived 525 bp of Fed tightening since early 2022 as if nothing happened. That impression would be wrong.

Exhibit 1: The picture of credit stress in loans changes after including LMEs

Note: Percentage of loans by count.
Source: PitchBook | LCD, Morningstar/LSTA Leveraged Loan Index through 12/31/24, Santander US Capital Markets

The big change is the surge in what is euphemistically called liability management exercises, or LMEs. LMEs cover a multitude of ways for companies to restructure balance sheets and get access to new cash without the expense of bankruptcy. LMEs also give private equity sponsors and other shareholders a better chance to preserve their stakes. The exercises almost always signal serious credit stress. Including LMEs puts the rate of serious credit incidents to 4.70%, about the rate at the peak of pandemic. That rate looks a lot more like stress, and LMEs could rise further if persistently high interest expense start to exhaust corporate cash reserves.

The controversial and unpredictable aspects of LMEs is that they often amount to efforts by the borrower, their equity sponsor, a subset of current lenders or some combination of these parties to pull the rug out from under other lenders or investors in a loan. That is a bit oversimplified because the borrower can end up better off after an LME, so there are benefits to the borrower and its sponsor that motivate an LME. But investors can end up on opposite sides of a knife’s edge. The winning lenders or investors in the most aggressive LMEs end up with loans that price closer to par with high expected recovery should the borrower defaults, and the losers end up with the original loan trading at a price reflecting recoveries often below 50%. Among loan investors, LMEs create clear winners and losers.

As an example of an LME, take a loan originally taken by Serta Simmons Bedding in 2016 and sold into the leveraged loan market. The loan included language recognizing the longstanding norm in corporate finance that similarly situated lenders should get treated the same way, or ratably. Under ratable treatment, if Serta later wanted to buy back 20% of the loan, for instance, it would have to buy back 20% of each investor’s position and not just quietly go to a small group that happened to own 20%. The Serta agreement also said that any changes to ratable treatment would need investors’ unanimous consent.

The Serta loan had two exceptions to ratable treatment. Serta could buy back a portion of its loan either through a Dutch auction open to all lenders or through open market purchases. The agreement laid out comprehensive guidelines for the Dutch auction. However, it neither defined nor discussed the open market purchases. That became the loophole that the LME drove through.

By 2020, Serta needed more cash. It went to some but not all of its 2016 lenders and signed a new agreement. The included lenders would provide $200 million in new cash in exchange for a package of debt. That package included $100 million in first-out super-senior debt, and the included group would exchange $1.2 billion of their first- and second-lien positions for $875 billion in second-out super-senior debt. It was a good deal for the company and the included investors. The company raised cash and lowered its debt load, and the included lenders cut their holdings, which were trading below par, and jumped the creditor line. Everybody else ended up with deeply subordinated debt that plunged in price. The excluded lenders sued, claiming Serta had not conducted open market purchases, and on the last day of 2024 the U.S. Court of Appeals for the Fifth Circuit agreed and nullified the 2020 deal (case 23-20181). In the meantime, Serta filed Chapter 11 bankruptcy in January 2023.

The Serta loan story is an example of an LME called a non-pro rata up-tier transaction and just one of many ways loan investors can suddenly find themselves either winners or losers based on nuances of credit agreements. This has pushed evaluation of loans beyond traditional credit fundamentals to include the risk of hand-to-hand combat with other investors. Heavy demand from loan investors in recent years and the resulting loose credit agreements have set the stage for this combat, and interest expense pressure has clearly sounded the opening gun.

The risk of hand-to-hand combat has changed the ways investors manage loan portfolios. Many now scour documentation for provisions that might encourage conflict and closely track loan prices for the first sign of any fundamental credit stress that might trigger conflict. Investors are also often hurrying to create ad hoc lender groups or co-ops able to control enough of a loan to end up on the winning side of any lender-on-lender violence. Any investor that does not do these things raises the odds of ending up a loser.

For credit investors generally or others tracking the health of corporate balance sheets, the rate of defaults and LMEs echoes signs of stress elsewhere. S&P recently reported that bankruptcy filings among companies it rates closed last year above the number in 2020 and at the highest count since 2010. The agency did not report bankruptcies as a percentage of rated companies, unfortunately. Leveraged loans in the last quarter of 2024 also saw three times as many downgrades as upgrades, more than double the low point of late 2023. Other indicators are more favorable, with the S&P leveraged loan distress ratio at its lowest point since mid-2022, although that could simply mean historically tight spreads are allowing fewer loans to trade beyond the distressed spread threshold.

For investors in leveraged loans and in CLOs, things are trickier today than in 2020. In 2020, an investor might project a default rate, assume some recovery between 50% and 80% and see if the available spread on the loan adequately covered the risk. Today, an investor can project a rate of default and LME, but recovery assumptions can swing dramatically depending on whether the investor ends up on the winning or losing side of an LME. Under those circumstances, knowing whether spread covers the risk is a lot harder.

With the Fed in the best case likely to ease slowly this year, fewer highly leveraged companies will be able to draw on cash reserves to outrun interest rates. Private equity sponsors could end up looking more aggressively for LMEs to preserve their best companies. As a general bellwether of corporate credit, that looks like the thing to watch. For investors in loans and in CLO equity and mezzanine debt, that could be the difference between winning and losing.

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The view in rates

With the strong December jobs report, the market has reduced it expectations for cuts next year to a single one. The Fed’s median dot for the end of 2025 shows two cuts. At the very least, the December report gives the Fed leeway to take its time. But with discussions of tariffs, changes in immigration policy and an active battle underway in Congress over federal spending, the range of potential paths next year for the Fed is getting wider by the day. Rate volatility still does not look fully priced into options markets, especially for longer tenors.

Other key market levels:

• Fed RRP balances stand at $179 billion as of Friday, down $58 billion in the last week. With RRP at 4.25%, Treasury repo at 4.34% and MBS repo at 4.36%, cash has much better alternatives than RRP.
• Setting on 3-month term SOFR closed Friday at 429 bp, unchanged on the week.
• Further out the curve, the 2-year note traded Friday at 4.38%, up 12 bp in the last week. The 10-year note traded at 4.77%, up 19 bp in the last week.
• The Treasury yield curve traded Friday with 2s10s at 38 bp, steeper by 6 bp in the last two weeks. The 5s30s traded Friday at 37 bp, flatter by 4 bp over the same period
• Breakeven 10-year inflation traded Friday at 245 bp, up by 9 bp in the last week. The 10-year real rate finished the week at 232 bp, up 8 bp in the last two weeks.

The view in spreads

Implied rate volatility looks likely to stay high. Volatility will likely depend on the tariff, immigration and fiscal policies implemented by the incoming administration.

The Bloomberg US investment grade corporate bond index OAS traded on Friday at 80 bp, unchanged in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 138 bp, unchanged in the last week. Par 30-year MBS TOAS closed Friday at 48 bp, wider by 2 bp in the last week.

The view in credit

Fundamentals for consumer and corporate credit continue to look stable. Most investment grade corporate and most consumer balance sheets have fixed-rate funding so falling rates have limited immediate effect. The rate of serious delinquency in residential mortgages and of loans in foreclosure have barely changed over the last year. Leveraged loans are showing signs of stress, with the combination of payment defaults and liability management exercises, or LMEs, often pursued instead of bankruptcy back to 2020 post-Covid peaks. If the Fed only eases slowly this year, fewer leveraged companies will be able to outrun interest rates and signs of stress should increase.