Are Defaults Happening?

This article is a translation of Greg Obenshain’s original piece, Where are all the defaults?, with the author’s own commentary added.

Historically, whenever the Fed’s policy rate has risen sharply, default rates have spiked. This happens as vulnerable borrowers get squeezed between higher borrowing costs and slowing growth. Looking only at Chapter 11 bankruptcy filings, it appears that this history is repeating in the current rate-hiking cycle as well. Even though the economy so far seems to have avoided a recession, Chapter 11 filings are on the rise.

Typically, when bankruptcy rates surge, high-yield spreads widen as well. But so far, high-yield spreads have barely moved.

If we tried to predict high-yield spreads solely from bankruptcy rates, we would expect spreads to be around 7.0% today, not 4.4%. And yet in 2023 alone, 14 bankrupt companies each had more than $1 billion of debt, including Mallinckrodt, Yellow Corp, Wesco Aircraft, Avaya, and Party City. In other words, it is clearly not just small companies that are going under.

One reason we think high-yield spreads have not yet blown out is that lower-rated borrowers with higher default risk have been migrating out of the high-yield bond market into the private credit market. According to Moody’s, the decline in the number of issuers with B3 ratings reflects the fact that these issuers have exited into private credit (the direct lending market). Moody’s states this explicitly: “Ultimately, we believe the growth of alternative asset managers will contribute to systemic risk. This group of lenders, consisting of private equity and private credit firms, lacks the careful and detailed regulation and supervision that applies to the more tightly regulated banking sector.”

The leveraged loan market, which can be thought of as the rated loan market, is currently about $1.3 trillion in size—roughly as large as the high-yield bond market. The private lending market, which consists of unrated loans, is much harder to measure, but it is also reported to exceed $1 trillion, and reports suggest that most of this growth has come from riskier borrowers.

According to Moody’s, 62% of the entire rated credit universe—across both loans and bonds—is rated B2 (commonly referred to simply as B) or below. Moody’s notes that “the high-yield bond market generally favors higher-quality Ba [Moody’s term corresponding to BB] issuers, while the leveraged loan market is concentrated in LBOs with liquidity constraints stemming from the Fed’s aggressive tightening.” Looking at the high-yield bond market in isolation, we can see that over time the share of BB-rated issuers has risen, while the share of B2 and below has declined as lower-rated borrowers have migrated into private lending markets.

Moody’s annual default data are highly informative. For the 54 cases (out of 62) where Moody’s could identify both loan and bond amounts, they tracked $35 billion of loan defaults and $26 billion of bond defaults. Thirty of these capital structures had only loans, 12 had only bonds, and 12 had both loans and bonds. Of the 62 defaults, 37 were distressed exchanges; among those, 19 involved loan-only capital structures and 10 involved bond-only structures. Distressed exchanges—where borrowers renegotiate directly with creditors outside of formal bankruptcy—often do not show up in default statistics, nor are they captured in the Chapter 11 filing counts shown earlier in this article. In that sense, the current episode is somewhat unusual. Defaults are very much still occurring; they are just happening in different places than before and via different mechanisms (distressed exchanges) than in the past.

That does not mean all loans are struggling. In fact, BKLN, a loan ETF with $4.4 billion in assets, has benefited from the high base rates on loans and has returned 9.1% year-to-date. However, this fund invests more than half of its capital in BB or BBB credits and holds less than 1% in CCC loans, leaving it with relatively little exposure to lower single-B issuers—where many of the most vulnerable companies are likely to sit. The composition of ratings in the market matters when thinking about defaults. And a large share of lower-rated credit has migrated into private credit markets.

Many rating agencies track the share of companies rated B3 (also referred to as B-) or below as a leading indicator of defaults. The higher the share of B3-and-below companies, the higher the potential default rate. As of September 30, Moody’s list of issuers rated B3 negative or lower included 239 companies, representing 16% of the speculative-grade universe—up from just over 10% at the trough in May 2022. Sectors where such issuers account for more than 30% of Moody’s-rated universe include healthcare, aircraft and aerospace, defense, and consumer products, while sectors with the fewest such issuers include oil and gas, forest products, metals and mining, other energy, and lodging.

But if a large volume of low-rated loans is being originated in the loan market, should we expect high-yield spreads to remain contained even in a recession? It is true that the high-yield bond market is more resilient in some respects: it has a higher concentration of stronger issuers, and bond issuers do not need to immediately reprice their debt (64% of high-yield maturities fall after 2027). Still, there are plenty of fragile issuers in high yield—45% of issuers are rated B2 or below. Even if we recalculate historical high-yield spreads under the assumption that today’s ratings mix applied throughout history, the long-run behavior of high-yield spreads does not change much.

Why doesn’t it change much? Because spreads are highly skewed. Spreads on lower-rated credits (CCC and B) widen far more than BB spreads during crises, and thus drive the overall average. In fact, the historical series for single-B spreads and for broad high-yield spreads tend to overlap. You can think of the high-yield spread as effectively tracking the single-B spread—and single-B credits are typically the ones most vulnerable to macroeconomic shocks.

Rising interest rates are indeed putting stress on highly leveraged, floating-rate borrowers, but so far the lack of a recession has limited the impact on bond issuers. That does not mean they are insulated from macro risk. Spreads still have room to widen from here; it is just that the economy has proven more resilient than expected up to this point.