Leveraged loan 'Weakest Links' soar as investors eye default picture

The count of US leveraged loan Weakest Links — a demonstrated indicator of future potential default activity — increased for a fifth consecutive quarter in September as leveraged borrowers increasingly grapple with costlier financing terms amid the most aggressive interest-rate-hiking cycle in decades.

Weakest Links are loan issuers rated B-minus or lower (excluding defaulted deals) by S&P Global that have a negative outlook or implication. The analysis is based on credits in the Morningstar LSTA US Leveraged Loan Index. However, if a credit exits the index it remains in the Weakest Links universe until its rating is withdrawn or until it defaults, or the issuer nets an upgrade or improvement in outlook to its corporate credit rating.

The number of these at-risk loan issuers tracked by LCD increased to 175 as of Sept. 30, up 9% from June and 22% from December. In the last 12 months the Weakest Links cohort grew by 52%. For reference, the size of the cohort ballooned during the COVID-19 pandemic, peaking at 329 in June 2020. The latest reading, however, exceeds pre-pandemic levels.

The recent activity brings the Weakest Links share of the $1.4 trillion US leveraged loan asset class to 13%, up from 12% in the previous quarter and 9% a year ago. Although the current level is considerably lower than the pandemic peak — 25% in June 2020 — it exceeds the final reading for 2019 (11%).

On the bright side, the number of restructurings in this analysis — be that a distressed exchange or payment default — was unchanged in the third quarter, at 18, though that’s up from seven at the end of 2022. Indeed, September was the first default-free month this year, based on the constituents of the Morningstar LSTA US Leveraged Loan Index. As a result, the trailing 12-month loan default rate by amount fell to 1.27% at the end of September, down nearly 50 bps from the end of July.

Out of the 175 companies in the latest cohort of Weakest Links, 34 joined in the third quarter, mostly due to a worsening outlook, meaning these borrowers already had a B-minus or lower rating in the first quarter. Downgrades played a part too, however, as eight borrowers moved from the B-flat category into B-minus or CCC-plus territory. For example, S&P Global Ratings downgraded telecommunications company Lumen Technologies by two notches last quarter, to CCC+, from B, retaining a negative outlook, with the agency citing weak cash flow and approaching debt maturities in 2025 and, more importantly, in 2027.

Two issuers — Level 3 Communications and CenturyLink Group — have seen their corporate credit rating lowered by five notches in the space of one year, from BB to CCC+.

Looking at sector diversification within the Weakest Links cohort, technology and health care now share the top spot, accounting for 15% each. The count of riskiest borrowers rose for both sectors over the last 12 months but health care rose more drastically, from 11 to 27 issuers. Last quarter, five health care borrowers joined the list of Weakest Links. For example, S&P Global Ratings on July 24 downgraded Exactech to CCC, from CCC+, and revised its outlook to negative, from stable, with the agency citing a company product recall and an approaching revolver maturity.

Although the chemicals/plastics and telecom sectors have a lower count of at-risk borrowers, their presence in the Weakest Links jumped dramatically over the last year. At the same time, the leisure industry continues to recover from the wave of pandemic-induced downgrades, and it's one of only a handful of sectors that have the same or fewer Weakest Link loans now than a year ago.

The steady climb in Weakest Links comes alongside an increase of ratings downgrades following the start of the rate-hiking cycle early last year, though downgrades have moderated in recent months. Over the last 12 months, 23% of loans backing companies in the Morningstar LSTA US Leveraged Loan Index have been downgraded, a touch below 24% seen in the prior three months (on a rolling 12-month basis). However, a year ago this metric stood at just 15%. A jump in downgrade activity, as the below chart shows, can be a forward indicator for defaults.

The recent slowdown in downgrade activity has kept the ratings mix of the index roughly unchanged from the prior quarter. The share of borrowers with a CCC+ rating declined slightly in September, to 6%, from 6.4% in June, although it remains elevated relative to the 4.1% figure at the end of 2022. It remains below the 7.5% threshold level closely watched by CLOs, the largest holder of leveraged loans. At the same time, the share of the index rated B-minus remains near record-highs, at 27.6%, down slightly from the all-time record of 29.7% at the end of February.

While the underlying metric of rising Weakest Links denotes potential for an uptick in distress and restructurings down the line, the rate at which Weakest Links became defaults has slowed dramatically in recent years due to extremely accommodating financing conditions in 2021 and the first half of 2022. Just 14% of 2021 year-end Weakest Links have defaulted so far. However, the year-end 2022 cohort is not holding up as well, with 11.9% of these borrowers defaulting in the first nine months of 2023, as lending conditions tighten and interest costs rise drastically.

This article originally appeared on PitchBook News