Rising interest rates could lead to rating downgrades and defaults on senior secured loans*, also known as leveraged loans. A blog article published around two months ago pointed out these warning signs. In the meantime, short-term US interest rates have risen to over 3 percent. The consequences can now be felt.
Outflows and the first defaults
In May, the senior secured loans segment recorded significant outflows for the first time since October 2020. At the same time, three loan debtors went bankrupt – the highest number since 2020. The default rate rose slightly as a result, but remains at a low level of 0.8 percent.
In some areas, however, there are initial signs of stress. For example, in the healthcare and media sectors, over half of loans trade at a price level commonly referred to as "distressed". In addition, we can see that the lower credit rating segments came under more pressure than loans from borrowers with a higher credit rating.
Poor performance in May as a harbinger of things to come?
In May, senior secured loans recorded the sharpest drop in performance since May 2020 with a decline of 2.8 percent. For comparison: global corporate bonds generated a performance of around +0.5 percent in the same period. Since then, senior secured loans have been able to gain some ground again, partly due to the very low level of new issue activity.
Nonetheless, we expect performance to come under pressure again in the medium term, as the negative combination of high inflation, weaker growth and rising interest rates is a major challenge for the weak debtors.
*Senior secured loans, also known as leveraged loans, are securitised loans to highly indebted US companies whose coupon payments are linked to a short-term, variable interest rate. With rising interest rates in the current market environment, investors can therefore enjoy higher coupon payments and do not have to fear any direct negative performance effects. However, the increase in coupon payments is increasingly placing a burden on debtors with poor credit ratings.
