Leveraged loan default rate, distress ratio climb amid volatility

Bankruptcy filings courtesy Cineworld and Phoenix Services lifted the default rate of the Morningstar LSTA US Leveraged Loan Index to 0.90% by principal amount. This marks the highest level for loan default rates since June 2021, as the market moves off post-crisis record lows and as distress levels rise.

By issuer count the default rate, at 0.85%, is up from a record low of 0.26% in April.

LCD’s criteria for default rates excludes distressed exchanges.

Propelling default volume in September, Cineworld became the largest index default since McDermott International in 2020, putting $3.49 billion of term loans into bankruptcy.

Just two years before the Covid outbreak, Cineworld had taken on $4.1 billion of debt to fund the Regal acquisition. Hit with a significant deterioration in the company’s operating and financial performance as pandemic-related shutdowns persisted, the company ultimately sought Chapter 11 protection in bankruptcy court in Houston, citing a total financial debt pile of $5.35 billion, and another $4 billion of lease commitments as of the Sept. 7 petition date.

Cineworld is held in 40% of US CLO portfolios, according to Fitch.

Also tripping an index default, Phoenix Services, a provider of services to steel mills, filed for Chapter 11 reorganization in Delaware bankruptcy court.

According to materials filed with the bankruptcy court, the company’s customer contract portfolio became uneconomical over the past several years as a result of cyclical industry headwinds, including inflation and rising fuel costs, that have bid down returns on new contracts; existing contracts with suboptimal terms; and discrete operational challenges at the company’s sites.

The filing added that the liquidity strain this has placed on the company was compounded by the company’s capital lease payments, rising interest rates, and the company’s inability to finance its substantial capital expenditures.

S&P Global Ratings downgraded the company to CCC+ in late April, and Moody’s downgraded it to Caa1 in mid-May, with both agencies citing weakening results. The company said it would use the Chapter 11 proceedings to renegotiate key customer contracts as a prelude to a reorganization plan providing for “significant deleveraging and new money capitalization.”

Phoenix placed its (originally) $465 million first-lien term loan in 2018 to support Apollo’s acquisition of the company.

Technical distress
Looking at the state of play for potential trouble down the line, the volume of performing leveraged loans priced below 80 cents on the dollar (an anecdotal marker of distress that has shown to be a forward indicator for heightened default activity) increased dramatically in what was a grueling month for risk assets in September.

LCD data shows that nearly $83 billion of performing loans in the Morningstar LSTA US Leveraged Loan Index were priced at less than 80 cents on the dollar on Sept. 30. To put this into perspective, this is the largest volume of loans at distressed levels since July 2020 — two months before the default peak of September 2020.

This translates to nearly 6% of performing loans in the index that are now priced below 80, up from 3% at the end of August. By issuer count, the distress ratio jumped to 6% in September, from 4% in August.

Loans priced below 90 cents on the dollar — indicating both idiosyncratic risk and broader market stress — now represent nearly 20% of the index. At the end of 2021, just over 2% of the index fell below this level.

At the sector level, Internet & Direct Marketing Retail, Household Durables, IT Services, Health Care Providers & Services, and Beverages take the top five slots for loans below the 80 threshold.

Continuing a trend lower in rating actions, downgrades outpaced upgrades for a fourth consecutive month, on a three-month rolling basis (a 16-month upgrade cycle for the asset class was shattered in June). Again, on a rolling three-month basis, the downgrade count of loan facilities in the Morningstar LSTA US Leveraged Loan Index exceeded upgrades by 2.28x in September, up from 1.89x in August, 1.74x in July, and 1.32x in June.

A final note on the risk profile of leveraged loans — borrowers from the riskiest rung of the single-B ratings band now account for the largest share of the $1.43 trillion US leveraged loan asset class. This is the first time that's been the case in the 25-year history of the Morningstar LSTA US Leveraged Loan Index.

This article originally appeared on PitchBook News