![]() ![]() For borrowers with interest coverage of at least 3x, the long-term default rate is around 2% defaults rise to over 5% with interest coverage of 2-3x, then spike above 11% for borrowers with interest coverage below 2x. Rather, it is a borrower’s ability to continually service that debt-calculated via the interest coverage ratio-that is the primary indicator of default risk. As rates fell over the last decade, for example, default rates remained low even as leverage levels rose. Importantly, when assessing individual positions, higher debt levels do not necessarily translate to higher rates of default. Loans for LBOs have similar default rates as those for other purposes but take longer to default, 7 likely because PE owners are able to help companies navigate headwinds and provide additional capital infusions during times of distress. Direct lending in private credit is oriented towards financial sponsors and transaction activity. ![]() While private credit data is lacking, the HY and LL markets may provide clues into what is likely to transpire in a downturn. 6 As private credit gains increasing attention, we believe it is important to remember that the space is highly idiosyncratic with wide dispersion in positioning, as well as documentation and expertise, that can impact how different portfolios perform in down cycles. These benefits were on display during the depths of the pandemic, with private credit posting a lower default rate than leveraged loans as borrowers and lenders worked together to find solutions however, the pandemic was an exogenous market shock, and the market may perform differently during a prolonged down cycle. Private credit is more opaque, with borrowers tending to be smaller and on average lower rated, which may suggest higher default risk broadly, but the strategy may benefit from stronger covenants and closer relationships between borrowers and lenders. For leveraged loans, credit quality and covenant protections have fallen in recent years, 5 which could portend higher levels of distress and defaults if headwinds persist. The outlook for HY defaults is largely sanguine, 4 as credit quality in the HY market has improved in recent years and many borrowers took advantage of the low interest rate environment to refinance and push out maturities. Defaults remained low on an absolute basis in both HY and LL, as well as private credit however, the impact from rising interest expenses associated with floating-rate liabilities-much of which was left unhedged-is likely to have ramifications for the most indebted borrowers in 2023. 3 This is particularly true for PE-backed companies, many of which have been turning to private credit as an alternative to syndicated markets. 2 Indeed, despite rising levels of distress as reflected by market movements, there have yet to be signs of widespread operational difficulties or deterioration in fundamentals among borrowers. ![]() 1 In both markets, however, distress is defined based on trading levels rather than fundamentals. As rates began to rise and market headwinds converged in 2022, distress levels for both high yield (HY) and leveraged loan (LL) markets increased sharply from 2% to 9%, respectively, and have remained elevated early in 2023. ![]()
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