Where are all the defaults?

Default rates, defined broadly, are spiking, just in new ways and new places.
 

By: Greg Obenshain

A rapidly rising Fed funds rate has historically led to high levels of defaults as weaker borrowers get squeezed between higher borrowing costs and slowing growth. Just looking at the number of Chapter 11 bankruptcy filings, history would appear to be repeating itself in this rate-hiking cycle. Chapter 11 filings have increased even as the economy has thus far appeared to avoid a recession.  

Figure 1: 3M Count of Chapter 11 Bankruptcy Filings

Source: Bloomberg, FRED. Data through 9/30/2023.

Usually, as the bankruptcy rate spikes, the high-yield spread also rises. But so far, the high-yield spread has barely moved.

Figure 2: High-Yield Spread  

Source: FRED. HY spread data through 10/4/2023.

If we just used bankruptcy rates to predict high-yield spreads, then we’d expect high-yield spreads to be 7.0%, not the 4.4% we see today. It's not just small companies defaulting. Fourteen of the bankruptcies in 2023 have had over $1 billion of liabilities, including Mallinckrodt, Yellow Corp, Wesco Aircraft, Avaya, and Party City. 

One reason we believe high-yield spreads haven’t spiked yet is the migration of lower-quality borrowers—those most likely to default—out of high yield and into the private credit market. According to Moody’s, the number of issuers with B3 debt has fallen as these issuers have departed for private credit. They do not mince words about this: “Ultimately, we believe the growth of the alternative asset managers will contribute to systemic risk. This group of lenders comprise both private equity and private credit segments and lack prudential oversight, as opposed to the highly regulated banking sector.”

The leveraged loan market, which can be thought of as the loan market rated by credit agencies, is now about as big as the high-yield market, at around $1.3 trillion. The private credit market, which can be thought of as the loan market not rated by credit agencies, is much harder to measure but is reported to also be over $1 trillion. And much of that growth has come from riskier borrowers.

According to Moody’s, 62% of its rated universe, which includes both loans and bonds, is rated B2 (also known as B) or below, and, “In general, the high-yield bond market favors better-quality Ba [Moody’s term for BB] issuers, while the leveraged loan market is concentrated in LBOs that have had liquidity constraints on the heels of the Federal Reserve’s aggressive tightening.” Indeed, if we look at the high-yield market in isolation, we can see that the proportion of issuers rated BB has been increasing over time while the proportion of B2 and below issuers has declined as lower-rated borrowers have gone to the loan market.

Figure 3: Percent of High-Yield Issuers Rated B2 or Below vs. Those Rated BB

Source: Verdad Bond Database

The year-to-date default data tracked by Moody’s is informative. Where loan and bond amounts are available (54 of the 62), Moody’s has tracked $35 billion of loan defaults versus $26 billion of bond defaults. 30 were loan-only capital structures, 12 were bond-only capital structure, and 12 were capital structures with both loans and bonds. Of the 62 defaults listed, 37 were distressed exchanges and 19 of the distressed exchanges were for loan-only capital structures versus 10 for bond-only capital structures. Distressed exchanges, which are debt renegotiations conducted directly with lenders and outside the bankruptcy system, are often not captured by the default statistics and are not counted in the running count of Chapter 11s with which we started the article. This time is different in a way. Defaults are happening. They are just not happening where they used to, and they are happening in a different way (distressed exchanges) than they used to.

This does not mean that all loans are doing poorly. In fact, BKLN, a loan ETF with $4.4 billion of assets has returned 9.1% year to date as it benefits from higher underlying interest on its loans. But that fund holds more than half its funds in BB or BBB rated credit and less than 1% in CCC loans. It is not heavily exposed to the companies in the low single-B rating. That is where the most pain is likely to be. The rating composition of a market matters when considering defaults. And there has been a significant shift of low-rated credits to the private credit markets.

Many of the ratings agencies keep track of the percentage of companies rated B3 (also known as B-) or worse as a leading indicator of default. The higher the percentage of B3 or worse companies, the higher the potential default rate. As of September 30, Moody’s had 239 companies on its B3 Negative and Lower Corporate Ratings List, representing 16% of the sub-investment-grade universe and rising from its low of just over 10% in May 2022. The industries that have over 30% of the issuers in Moody’s rated universe are healthcare, aircraft and aerospace, defense, and consumer products. The industries with the fewest issuers on the list are oil and gas, forest products, metals and mining, energy: other, and lodging.

But if much of the lower-rated lending has been happening in the loan market, does this mean that we should expect that the high-yield spread will not rise if we hit a recession? It is true that the high-yield market has been more resilient both because it has higher-rated issuers and because bond issuers don’t need to reprice their debt right away (64% of high-yield bond maturities are after 2027). But there are still a healthy number of weak issuers in high yield. 45% of issuers are rated B2 or below. Even if we recast the historical high-yield spread as if today’s rating distribution were true throughout the spread’s history, it does not change the historical behavior of the high-yield spread much.

Figure 4: High-Yield Spread if Today’s Ratings Distribution Were Applied in the Past

Source: FRED, Verdad Bond Database Verdad Analysis. Recasting takes the sum of today’s rating weight by market value multiplied by the historical spread for that rating.

Why not? Because spreads are very skewed. Lower-rated spreads (CCC and B) widen much more than BB spreads during a crisis and therefore are the primary drivers of the average. In practice, the single-B spread and the high-yield spread historical series tend to overlap. The high-yield spread can be thought of as following the single-B spreads. And single B credits tend to be vulnerable to macroeconomic shocks. 

Higher rates are indeed causing stress among the highly leveraged, floating-rate borrowers, but bond issuers have thus far been less affected because the economy has not rolled over. That does not mean they are immune to macroeconomic risks. Spreads still have the capacity to go wider than they are today. The economy has just been more resilient than expected so far.