The world and financial markets had a tumultuous start to the 21st century. First, there was the bursting of the dot-com bubble and the largest financial crisis in more than 70 years. This was followed by the European debt crisis and when things appeared to have turned positive, the COVID-19 pandemic. Amid every crisis, support from developed nations’ central banks prevented the financial markets from collapsing under the pressure they exerted. Now, however, with inflation at its highest in 40 years (at above 8%), these central banks have had to shift their focus back towards maintaining price stability, ending the era of extreme monetary stimulus.
Central banks have been raising interest rates and may have to continue doing so to cool inflation, the unintended consequence of which could be a global recession. Banks with exposure to leveraged companies would have to monitor new and existing credits more diligently due to the potential deterioration in asset quality and the volatility in asset prices caused by market fears about rising defaults. Default rates are already rising and are expected to rise further in 2023.
What does this significant change mean for the leveraged-finance market going into 2023?
Default rate and default volume:
Fitch Ratings has forecast that the US institutional leverage loan default rate will increase to 2-3% in 2023 (in line with the 15-year average of 2.5%), versus previous forecasts of 1.5-2%, reflecting growing macroeconomic headwinds, including expectations of a US recession. S&P Global Ratings also expects the trailing-12-month speculative grade corporate default rates in the U.S. to reach 3.75% by September 2023.
The rate for 2023 equates to roughly USD45bn in terms of volume, the third largest since Fitch began tracking in 2007, well below volumes in 2009 and 2020. The agency expects about 60 defaults next year, nearly double the 36 defaults averaged over 2016-19 and a sharp acceleration from the 21 defaults year to date in 2022.
Sectors impacted: Media and telecommunications are likely to account for c.30% of default volume in 2023, resulting in default rates of 10% and 7%, respectively, primarily due to rising inflation, alternative distribution patterns, changes in the nascent technologies used by consumers and a slower recovery than expected from the effects of the pandemic. The technology and healthcare sectors are also likely to account for a significant share of default volume. Companies in these sectors already had high leverage and were further impacted by obsolescence owing to rapidly changing technology.
Fitch Ratings’ Market Concern total for US institutional leveraged loans rose to USD228.0bn in October 2022 from USD201.3bn in September 2022, the largest one-month increase since the start of the pandemic. The Market Concern total has increased by 39% since end-1Q22 and is the highest since end-2020.
A breakdown of the US institutional leveraged loan default rate by sectorMarket Concern Loans Total Highest Since March 2021 FITCH U.S. LEVERAGED LOAN DEFAULT INSIGHT
Fitch Ratings’ September 2022 Other Market-At-Risk Issuer list shows new additions, with technology leading with 41% of new additions, healthcare/pharmaceutical with 23%, building/materials with 17% and banking/finance with 9%. Nearly 30% of the issuers at the top of the list, accounting for 19% of volume, have a term loan falling due before end-2023. These sectors need to be watched closely, as they may generate significant defaults in 2023.
Regulatory and economic factors:
Introduction of new Basel reform: After having been delayed by a year due to the pandemic, Basel 3.1 (also known as Basel 4) is scheduled to be implemented on 1 January 2023. Although individual customers may not notice the changes, this would require new government regulations and change the way banks account for base capital, credit risk using standardised or internal models, and mandatory disclosures.
Geopolitical and macroeconomic uncertainties: Factors such as the conflict in Ukraine and their impact on energy prices, elevated inflation, and corporate borrowers’ inability to pass on these prices to consumers, supply-chain disruptions from the Russia-Ukraine War and lockdowns in China along with tightening monetary policy will likely continue to influence global financial markets. The Federal Reserve may keep interest rates on an upward trajectory, to curb inflation. Market participants expect interest rates to peak at 5.0%-5.25% in the second quarter of 2023. With a higher-interest-rate regime expected to be the norm in 2023 and a potential recessionary environment in the second-half of 2023, lenders will have to be cautious when providing new credits and more vigilantly monitor existing credit portfolios.
Sustainability and ESG debt financing
The issuance of environmental, social and governance (ESG)-linked debt financing (where the interest payable is tied to the delivery of ESG targets) increased four-fold to USD530bn in 2021, according to Bloomberg. With issuance of bonds with sustainability-linked pricing ratchets, issuers pay a lower coupon on their debt if pre-agreed ESG key performance indicators (KPIs) are achieved (or pay a higher coupon if targets are missed).
ESG debt financing is currently at a nascent stage in US leveraged lending markets. However, given the steps taken by the European loan market towards sustainability, this is a space to watch in 2023 as to whether the US debt capital markets can align their debt-financing goals with these sustainability targets to achieve a win-win situation.
The big question is how deep the recession expected in the latter half of 2023 will be. With demand cooling, how would highly indebted companies manage their cashflow, especially with refinancing options not being as cheap as they used to be? Banks would have to monitor their credits very carefully, and this would require enhanced expertise.
How Acuity Knowledge Partners can help
We continue to empower our stakeholders through continued monitoring of leveraged debt, delivering innovative solutions to new challenges, timely delivery of alerts on the latest news and detailed projections with quality credit reports to enable them to take action-oriented decisions.
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About the Authors
Gunjan Lahoty is a qualified Chartered Accountant and Company Secretary with more than five years of experience in financial analysis and credit underwriting. Currently , part of the Leveraged Lending team at Acuity Knowledge Partners handling US Corporate Clients. Prior to joining Acuity, she was part of Commercial Banking Credit Stewardship team of leading UK bank handling portfolio of Corporate and Commercial Clients.
Daanish Sharma has completed all 3 Levels of the CFA Program and has more than 3 years of experience in the Financial Services Industry. He is currently part of the Leveraged Lending team at Acuity Knowledge Partners handling US Corporate Clients. Prior to joining Acuity, he was part of Cirifort Enterprises Private Limited where he was a content writer for developing financial literacy courses
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