Leveraged loans’ performance is holding up well despite deteriorating credit quality among some of the borrowers, according to Ned Davis Research.
Total return (price increases plus interest payments) of these loans—which are made to highly indebted companies—gained 10.9% over the 12 months ending January 31, the research firm reported. The most recent report marked the eighth consecutive monthly boost in returns, wrote Ned Davis’ chief global financial strategist, Joseph Kalish, in a report.
The good tidings come shortly after the quality of lev loans, as they are known, soured in 2023, per stats from the Shared National Credit Report, a federal study group that tracks weak loans—defined as having, among other things, poor interest payment coverage and dropping collateral values.
Those troubled loans, known as “criticized assets” in banker-speak, rose 38.3% to $437 billion last year. They comprise one quarter of lev loans outstanding.
“Before that you have to go back to the [2008 global financial crisis] to find that big of an increase,” wrote Kalish. Technology, telecom and media were the most affected sectors, Ned Davis found.
Higher interest rates and tighter profit margins at lev-loan-borrowing companies are to blame for the expansion of troubled loans, Kalish observed. Possible future rate hikes raise the risk of default, as do earnings shortfalls.
Overshadowing the problem loans are the economy’s continuing strength and the prospect of lower interest rates set by the Federal Reserve, Kalish contended. The three-quarters of lev loans that are not troubled are where the total return advances have occurred.
While the loans’ situation could well go south if the long-predicted recession ever hits, the stable condition of lev loans is good news for borrowers. Lev loans ($1.7 trillion outstanding) are 4.1% of all U.S. fixed-income instruments.
The default risk is worsening but still small. The lev loan default rate rose to 1.53% at year-end 2023, up 0.81 percentage points from the year before. But the new level still is below the five-year average default rate of 2.67%, PitchBook research shows. Still, lev loans are not as bad off as high-yield corporate bond defaults, which stood at 2.4% at the end of last year.
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Tags: Banks, default rate, Federal Reserve, financial companies, Joseph Kalish, leveraged loans, Ned Davis Research