Apr 4, 2024 - Business

Rebound in credit markets hides growing corporate strain

Data: PitchBook LCD; Note: Includes repricings and maturity extensions; Chart: Axios Visuals
Data: PitchBook LCD; Note: Includes repricings and maturity extensions; Chart: Axios Visuals

The trillion-dollar leveraged loan market has officially shrugged off the dislocations of the high-rate era: Q1 borrowing activity hit near-record levels. But don't confuse a revival in the markets with a revival of company balance sheets.

Why it matters: One of the big questions after the Federal Reserve started aggressively tightening was how much rising interest costs would squeeze the finances of the most indebted companies.

  • A recent report from banking regulators including the Fed offers one way of answering that question — and it shows a big increase in leveraged loans that are considered troubled.

How it works: The leveraged loan market, like the high-yield bond market, is where high-debt companies with lower credit ratings borrow money. One big difference between the two is that while bonds lock in costs via fixed-rate coupons, the loans are floating-rate — so interest costs go up in real time along with the Fed's policy rate.

  • Investment banks provide these loans — but they immediately sell off most of the exposure to investors like mutual funds, hedge funds, insurance companies, and CLOs, in a process called syndication.

State of play: Borrowing activity in the market came to a near-standstill in 2022, as both banks and investors pulled back on their exposure to credit risk.

  • But that all changed over the last six months or so. Investors flooded back into credit as recession worries ebbed, pushing average loan prices up from a low of around 93 cents on the dollar last year to 97 now, according to PitchBook LCD.
  • Q1's $325 billion in deal activity was just shy of the 2021 quarterly peak, PitchBook data shows. (See the chart above.)

Yes, but: About that Fed report ... The Shared National Credit (SNC) Program examines the credit quality of a varied selection of loans held by bank and non-bank lenders.

  • What they found: Regulators deemed 26% of the below-investment-grade leveraged loans "non-pass" — meaning potentially troubled. The percentage is up by more than a third from the year before.
  • That amounts to $488 billion in non-pass leveraged loans, compared with $348 billion in 2022.

Another stat: PitchBook tracks a key cash flow metric, known as the interest coverage ratio, for leveraged loan borrowers — and it shows that on average, borrowers' excess cash has diminished significantly since the Fed started raising rates.

  • 75% of PitchBook's leveraged loan data set are private companies (many are owned by private equity firms) — so this balance sheet erosion doesn't show up in the S&P 500 earnings data that many investors focus on.

What it means: The balance sheets of leveraged companies, on average, have been deteriorating as one would expect in a higher-for-longer rate environment.

  • The recent surge in loan prices may seem disconnected from that fact, but prices are driven purely by supply and demand — there are more buyers than sellers now, says Andrew Milgram, chief investment officer at Marblegate Asset Management, which published an analysis of the SNC data.

The bottom line: The market revival is a positive in many ways — credit is readily available for companies that need to refinance, albeit more expensive than it was before 2022.

  • But disconnected prices run the risk of sending distorted signals about the economy, Milgram says.
  • Plus, money flows are fleeting. They can stop — or even reverse — as quickly as they started.
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