Why company defaults are creeping up

Company defaults are rising, but by an unfamiliar route. In past downturns bankruptcies followed a sudden fall in sales, or a breach of covenants that strict bank lenders chose to enforce. This time revenues are still propped up, at least on the surface, by inflation in prices, and covenant-lite loans give borrowers plenty of room. Defaults are climbing because floating-rate interest costs keep going up.

How the loans were written

Much of the debt now in trouble was arranged in 2020 and 2021, when leveraged loan issuance hit records and the benchmark rate beneath it sat close to zero. Leveraged loans pay a fixed margin over a floating benchmark, increasingly the Secured Overnight Financing Rate now that dollar Libor is due to cease at the end of this month, so every Fed increase passes straight into the coupon. The Fed has raised its target by five percentage points since March 2022. A borrower whose all-in rate was around 4 per cent two years ago can now be paying roughly double on the same debt, with no change in its business. Fitch's trailing default rate for US leveraged loans has climbed to around 3 per cent.

Floating rates bite

Policy rates are still above five per cent. Leveraged borrowers who took on floating-rate debt when money was cheap are now running short of working capital. Interest cover, once comfortable, has shrunk to the point where earnings barely meet the interest bill. These companies still have customers. They are failing because debt service eats every penny of the cash their operations produce.

A stylised example shows the squeeze. Take a company, bought by a private equity firm, that carries debt of six times its annual operating earnings, a common level for buyouts in those years. At an all-in rate of 4 per cent, interest takes about a quarter of earnings, leaving plenty for tax, investment and repayment. At 8 per cent, interest takes nearly half, and once capital spending and taxes are paid there may be nothing left. The business can be exactly as good as it was, and the owners' equity can still be worth very little.

Many borrowers bought interest-rate caps or swaps when they took on the debt, which cushioned the first year of increases. Those hedges run for limited periods, and replacing them now costs far more than it did when rates were near zero. The protection is thinning just as the burden it covered grows.

Why covenants no longer warn

In earlier cycles, maintenance covenants forced a conversation long before the money ran out. A borrower that breached a leverage test had to renegotiate, pay a fee or accept tighter terms, and lenders could step in while the business still had value. Covenant-lite loans, now the great majority of the market, drop those quarterly tests. Trouble surfaces only when a company misses a payment or runs out of cash, so defaults arrive later and recoveries tend to be lower. Many struggling borrowers avoid court altogether through distressed exchanges, swapping old debt for new at a loss to lenders, which the rating agencies count as defaults.

The previous default wave shows how different this one is. In 2015 and 2016 defaults rose sharply among energy producers after the oil price collapsed, a classic revenue shock confined largely to one sector. Today's pressure comes from the cost side and falls on any borrower with floating-rate debt and thin margins, from software to healthcare services. A sector shock ends when the price recovers; a rate shock lasts as long as the central bank keeps rates high.

Where the stress travels

Collateralised loan obligations, the largest buyers of leveraged loans, spread the pressure. Their rules typically cap holdings of loans rated CCC at 7.5 per cent of the portfolio, and a wave of downgrades pushes them towards that limit, making them reluctant to buy weaker credits. Borrowers that need to refinance then find fewer buyers for their debt. Private credit funds have lent heavily to mid-sized companies on similar floating terms, so part of the strain sits outside public markets, where it is harder to measure. Fixed-rate high-yield bonds are less exposed, since many issuers locked in low coupons and long maturities in 2020 and 2021.

Lenders win until they lose

For now the lenders are the winners. Loan funds and CLOs collect far higher coupons than they did two years ago, and private credit managers can lend to healthy companies on terms that banks, chastened by this spring's failures, are reluctant to match. The losers are the equity holders, usually private equity firms, whose stakes shrink as interest eats their cash flow. Sponsors can inject fresh equity or agree to extend maturities to keep a company alive, and many will. Where they walk away, the lenders take the keys, often on businesses that have been starved of investment.

The strongest counterargument is that defaults remain far below past recessions, when loan default rates reached double digits in 2009, and that rising nominal revenues still help most borrowers. That is fair, and a quick fall in rates would relieve many of them. The Fed's latest projections point the other way, with the median official expecting further increases this year before any cuts. The rating agencies' monthly default reports, second-quarter interest-cover figures and the share of CCC loans in loan-fund portfolios will show whether the pressure is spreading.

This default cycle is being driven by the cost of money. Higher base rates will keep wearing down companies that borrowed at floating rates without hedging, and defaults will probably keep rising for as long as rates stay above five per cent, with unhedged buyouts from 2020 and 2021 accounting for most of the casualties over the next year.