Credit cracks widen with distressed debt ballooning to $877 billion

LONDON – Multiple stress points are emerging in credit markets after years of excess – from banks stuck with piles of buyout debt, to a pension blow-up in Britain, to real estate troubles in China and South Korea.

With cheap money becoming a thing of the past, those may just be the start. Distressed debt in the United States alone jumped more than 300 per cent in 12 months.

Globally, almost US$650 billion (S$877 billion) of bonds and loans are in distressed territory, according to data compiled by Bloomberg. It is all adding up to the biggest test of the robustness of corporate credit since the financial crisis and may be the spark for a wave of defaults.

The strains are largely linked to aggressive rate hikes by the US Federal Reserve and other central banks worldwide, which have dramatically changed the landscape for lending, upended credit markets and pushed economies towards recessions, a scenario that markets have yet to price in.

“Many are likely to be slightly more complacent than they should be,” said Mr Will Nicoll, chief investment officer of private and alternative assets at M&G. “It is very difficult to see how the default cycle will not run its course, given the level of interest rates.”

Banks say their wider credit models are proving robust so far, but they have begun setting aside more money for missed payments, Bloomberg-compiled data shows. Loan loss provisions at systematically important banks surged 75 per cent in the third quarter against a year earlier, a clear sign that they are preparing for payment issues and defaults.

Most economists forecast a moderate slump over 2023. A deep recession, however, could cause significant credit issues because the global financial system is “vastly over-leveraged”, according to US hedge fund Elliott Management.

Right now, the outlook for economic growth is a concern. Rolling recessions are likely across the globe next year, with the US likely to slip into one in the middle of next year, Citigroup economists wrote in a note.

Mr Mike Scott, a portfolio manager at Man GLG, said “markets seem to be expecting a soft landing in the US that may not happen”, adding: “The leveraged loan market is something that we are monitoring as well.”

That market has ballooned in recent years. There was US$834 billion of leveraged loan issuance in the US last year, more than double the rate in 2007 before the financial crisis.

Leveraged loans have seen the “greatest build-up of excesses or lower-quality credit”, said UBS strategist Matthew Mish. Default rates could rise to 9 per cent next year if the Fed stays on its aggressive monetary policy path, he said. It has not been that high since the financial crisis.

Restrictive rates

Many investors may have been caught out by the Fed this year. They have consistently bet that the threat of recession would force the central bank to ease off, only to have been repeatedly burned by tough talk and tough action.

While the pace of hikes has slowed, Fed chairman Jerome Powell has been clear that interest rates still have to rise, and will stay elevated for some time.

In this new world of higher interest rates and greater risk aversion, there is already a squeeze on global banks, which have been left saddled with about US$40 billion of buyout debt ranging from Twitter to auto parts maker Tenneco. Lenders had expected to quickly offload bonds and loans linked to the acquisitions, but could not when the appetite for risky assets plunged as borrowing costs rose.

There is another reason for concern. The search for yield during quantitative easing was so desperate that borrowers could soften investor protections, known as covenants, meaning investors are far more exposed to the risks. For example, over 90 per cent of the leveraged loans issued in 2020 and early 2021 have limited restrictions on what borrowers can do with the money, said Oaktree Capital Management analysts.

Historically, corporates typically used a combination of senior loans, bonds that ranked lower in the payment scale and equities to fund themselves. Over the last decade, however, demand has allowed firms to cut out the subordinated debt, meaning that investors are likely to get less money back if borrowers default.

Higher borrowing costs could also have an impact on the collateralised loan obligation (CLO) market, which pools the leveraged loans and then securitises them with tranches of varying risk.

Mr Matthew Rees, head of global bond strategies at Legal and General Investment Management, is concerned about higher defaults in lower-tier portions of CLOs.

Pockets of volatility are already surfacing. In South Korea, credit markets were roiled when the developer of Legoland Korea, whose biggest shareholder is the local province, missed a loan payment. The fallout sent shorter-duration won corporate spreads to a 12-year high.

Asia was already dealing with the fallout from record defaults on dollar-denominated Chinese property bonds, which caused junk notes from China to lose almost half their value. Despite government efforts to support the market, the contagion risks spreading further as rising debt payments cause increased stress on borrowers in South-east Asia and India. A Vietnamese parliamentary committee recently warned of repayment difficulties at some developers. The meltdown is a signal that governments and central banks must tread carefully on fiscal issues, with market sentiment so fragile.

Britain provides another example of how quickly things can go wrong. Government bond yields soared after the country’s uncosted mini-budget in September, causing huge mark-to-market losses for pensions using so-called liability-driven investment strategies. The chaos meant that the Bank of England had to intervene to protect financial stability.

Variations on these issues are likely to be repeated as tighter lending conditions and increased caution take hold. BLOOMBERG