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US companies are defaulting on junk loans at the fastest rate in four years, as they struggle to refinance a wave of cheap borrowing that followed the Covid pandemic.

Defaults in the global leveraged loan market – most of which are in the US – rose 7.2 percent in the 12 months to October, as high interest rates took their toll on heavily indebted businesses, according to in a report from Moody’s. That’s the highest rate since the end of 2020.

The rise in companies struggling to repay loans contrasts with a more modest rise in defaults in the high-yield bond market, underscoring how much risk America’s corporate borrowers are drawn to. fast growing loan market.

with leveraged loans – high-yield bank loans sold to other investors – with floating interest rates, most companies that borrow when rates are at their lowest during the pandemic struggle under the high cost of borrowing in recent years. Many are now showing signs of pain even as the Federal Reserve brings rates back.

“There is a lot of issuance in the low interest rate environment and the high rate pressure required time to top up,” said David Mechlin, credit portfolio manager at UBS Asset Management. “This (default trend) could continue until 2025.”

Penalty lending costs, along with lighter covenants, lead borrowers to find other ways to increase this debt.

In the US, default rates on junk loans rose to a decade high, according to Moody’s data. The prospect of rates staying higher for longer — the Federal Reserve last week marked a slow pace of defaults next year – may continue high pressure on default rates, say analysts.

Many of these defaults involve so-called distressed loan exchanges. In such deals, loan terms are revised and maturities are extended as a way to enable a borrower to avoid bankruptcy, but investors are paid less.

Such deals account for more than half of defaults this year, a historic high, according to Ruth Yang, head of private market analytics at S&P Global Ratings. “If (a loan default) damages the lender it’s considered a default,” he said.

“A number of low-rated loan-only companies that cannot tap the public or private markets will have to restructure their debt by 2024, resulting in higher loan default rates than of high-yield bonds,” Moody’s wrote in its report.

Portfolio managers are concerned that this higher default rate is the result of changes in the leveraged loan market in recent years.

“We’ve had a decade of unfettered growth in the leveraged loan market,” said Mike Scott, a senior high yield fund manager at Man Group. Many of the new borrowers in sectors such as health care and software are relatively light on assets, meaning investors are likely to recoup a small fraction of their cost in the event of a default, he added. .

“(There’s) a nasty combination of a lack of growth and a lack of assets to recover from,” thought Justin McGowan, corporate credit partner at Cheyne Capital.

Despite the rise in defaults, spreads in the high-yield bond market are historically tight, the smallest since 2007 according to Ice BofA data, in a sign of investors’ appetite for yield.

“Where the market is right now, we’re pricing on impulse,” Scott said.

However, some fund managers think that the spike in default rates will be short-lived, as Fed rates are currently falling. The US central bank cut its benchmark rate this month for the third meeting in a row.

Brian Barnhurst, global head of credit research at PGIM, said lower borrowing costs should provide relief to companies borrowing in the debt or high-yield markets.

“We don’t see a pick-up in defaults in any asset class,” he said. “In fact, that relationship (between leveraged loans and high-yield bond default rates) diverges probably as late as 2023.”

But others worry that distressed exchanges indicate underlying stresses and merely postpone problems until a later date. “(It’s) well and good to kick the can down the road when that road is going down,” said Duncan Sankey, head of credit research at Cheyne, referring to when conditions are more favorable for borrowers. .

Some analysts blame the loosening of credit restrictions on loan documentation in recent years for allowing an increase in troubled exchanges that hurt lenders.

“You don’t put the genie back in the bottle. Weak (documentation) quality has really changed the landscape, in favor of the borrower,” said S&P’s Yang.