Lenders Beware: Rising Default Risk Requires a Proactive Approach
As last year’s economic mood shifted from mild concern about transitory inflation to fears of a recession, rising interest rates raised the threat of default risk. While investment banks and credit rating agencies expect default risk to remain relatively subdued in 2023, $298 billion worth of leveraged loans are due to mature before the end of 2025 (according to data from Morningstar LSTA US Leveraged Loan Index and Leveraged Commentary & Data), prompting borrowers to attempt to refinance their debts to avoid contentious battles and lender negotiations as maturity dates get closer.
Challenging times create opportunity. Lenders, both traditional banks and private credit funds, will eagerly deploy their capital to meet increased demand for refinancing — at the right price. The most proactive players will likely perform better in 2023; i.e., issuers that take steps to refinance their existing debt with new lenders and lenders that take pre-emptive steps to work with issuers before trouble emerges or gets worse.
Borrower Conversations to Preempt Defaults
Signs of the looming maturity wall are already here. In December 2022, Fitch Ratings predicted that default risk for high-yield bonds and leveraged loans will jump to 2.5%-3.5% and 2.0%-3.0%, respectively, in 2023. At the individual-issuer level, news about distressed retailers preparing for bankruptcy started to break at the beginning of January.
This means that lenders need to be proactive with their borrowers to get ahead of defaults as economic conditions worsen. Where lenders believe that there is a viable business that will continue to operate with restructured capital, lenders have ample means to work with issuers and potentially forestall loan defaults by granting waivers for covenant breaches:
- Equity cure: one of the most common tools of default mitigation. Lenders work with equity owners of the company to inject equity capital into a business to cure a default on a covenant in the terms of the credit agreement.
- Debt-to-EBITDA recalculation: an adjustment to EBITDA so that covenant requirements like the interest coverage or debt coverage ratio (as defined by the credit agreement) are not impaired.
- Asset divestment: the borrower could agree to sell an asset to generate proceeds to pay down debt on their balance sheet and/or use the proceeds to satisfy interest payments.
- Management change: lenders could also propose a change in management in exchange for a waiver for a covenant breach, although this is an extreme option.
The most important step a lender can take ahead of potential borrower default is to open the lines of communication with their borrower’s financial management. If the borrower breached a covenant in the past quarter, for instance, or expects to breach a covenant in the next quarter, lenders should hear about that potential default as soon as management becomes aware. If a lender anticipates a missed interest payment, they should immediately discuss possible solutions with the borrower. Without proper communication, defaults can cause costly surprises and damage relationships and reputations. Lenders may be more willing to work with borrowers that provide timely information to the lender, have a good handle on their business, and forecast performance accurately.
Lenders can also take early action by identifying debt facilities with exposure to industry-related recessionary and geographical risk. Companies that manufacture and sell consumer products will face heightened risk as consumer buying habits change. In the automotive sector, lenders should keep a close eye on facilities they’ve provided to tier-2 and tier-3 suppliers, which will likely be hit hard if current economic conditions continue. U.S. auto sales saw volume drop below 14 million (Edmunds via CNBC) to the lowest level since 2011, a potential bellwether for what the auto sector may see in early 2023.
Lenders should start discussions as soon as possible with borrowers connected to geopolitically risky situations such as Russia’s war in Ukraine and the turmoil in the Middle East. Any contractual revisions to facilities with exposures to these regions will likely require much more time to complete because of government restrictions.
Refinancing at a Premium
Even as debt markets threw the price dynamics of loans and bonds into disarray, refinancing activity in the leveraged loan market picked up in the fourth quarter of 2022, according to PitchBook’s LCD, rebounding from very low levels earlier in the year to become the primary driver of new issuance.
Although pricing will remain expensive for borrowers, lenders should expect increased refinancing activity as a record level of leveraged debt comes due over the next few years. The debt maturity wall in 2024 and 2025 will likely force borrowers to attempt to refinance to avoid contentious battles and lender negotiations as maturity dates get closer. Lenders are prepared with a massive amount of capital to meet this demand. Combine that with desperate borrowers and you have an opportunity—for the right price.
In today’s debt market, price is king. Increasingly skeptical lenders will dictate terms far less attractive than those of the past decade. Despite higher prices, some borrowers will look to refinance with existing lenders. Many more will likely seek out new sources in search of better terms, prices, and transaction speeds. Private credit funds are expected to play a large role in filling this demand, given their ability to execute deals more quickly than their traditional counterparts.
While rising default rates might suggest that lenders will shift away from the so-called “covenant-lite” loans that defined the last decade, we have yet to see lenders enact stricter covenants on new issues or via amendments. For now, these lenders seem satisfied by higher prices and robust interest coupons.
The era of cheap money is over. Default risk is on the rise. Lenders that take early action will position themselves to not only mitigate the challenges of borrower default but also find opportunities in a rapidly changing lending environment.
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