Companies rated as junk have ‘significant exposure’ to Fed rate hikes, with growth in the leveraged loan market ‘the root cause of this vulnerability’, Deutsche Bank warns

By Christine Idzelis

“U.S. junk-rated debt is now 50% floating rate today, an all-time high,” says Deutsche Bank’s Jim Reid

According to Jim Reid, head of thematic research at Deutsche Bank, publicly traded companies in the United States have “significant exposure” to Federal Reserve interest rate hikes, raising concerns about defaults. payment as a potential recession looms.

In an emailed note Tuesday, Reid reviewed companies’ exposure to floating rate debt. “While the overall exposure of US and European companies is low, US and European companies rated as junk have significantly higher exposure,” he wrote.

“U.S. junk-rated debt is now 50% floating rate today, an all-time high,” Reid said in the note. “The rapid growth of the leveraged loan market is at the root of this vulnerability,” he said, pointing to the chart below.

Leveraged loans are a form of floating rate debt that can be considered risky because they are typically used to finance companies rated below investment grade or in junk territory. Private equity firms use leveraged loans to help fund their buyouts, with the acquired companies bearing the debt burden.

Highly indebted companies may find it more difficult to meet their obligations in the event of an economic downturn.

While “maturity walls” make a difference, “leverage is up to twice as large in our models explaining historical defaults,” Reid said. “High debt-to-sales ratios will expose very high leverage when profit margins compress (assuming a recession), leading to troubled exchanges and missed interest payments.”

The U.S. loan market is “most exposed”, due to lower ratings, industry composition and greater exposure to higher rates, he warned.

Read: This is not a “close your eyes and buy anything” type of market

Investors fear that the rapid pace of Fed rate hikes aimed at calming the economy in an effort to rein in high inflation could tip the United States into a recession. Central bank monetary policy tightening works with a lag.

Deutsche Bank has forecast defaults on US high-yield corporate bonds could climb to 4.5% by the end of 2023, with US leveraged loans potentially registering a higher rate of 5.6 %, according to Reid’s note. But by the second half of 2024, “we expect defaults to peak” at 9% in US high yield and 11.3% in US loans, he wrote.

The SPDR Blackstone Senior Loan ETF (SRLN), which offers exposure to lower-quality floating rate loans, has lost around 5% so far this year on a total return basis through Tuesday, according to data from FactSet. That compares to a decline of nearly 16% for the S&P 500 on a total return basis over the same period.

-Christine Idzelis

 

(END) Dow Jones Newswire

11-22-22 1706ET

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