US default landscape revisited

From a US high yield (HY) perspective, the month of May turned out to be one of note – for the first time since December 2022, no US HY defaults were recorded, with not one instance of a bankruptcy filing or a missed interest/principal payment. Thus far in 2024, the default landscape has turned out to be more benign than expected, relative to both market forecasts and historical standards. On a trailing-twelve-month (TTM) basis, default rates for US HY bonds and US leveraged loans stand at 2.0% and 3.3%, respectively (figures noted are par dollar-weighted and include distressed exchanges). Coming into the year, JP Morgan forecasts called for default rates of 2.8% (US bonds) and 3.3% (US leveraged loans). Putting things into historical context, 2024 default activity is also tracking favorably and in line with 25-year average default rates of 3.4% (US bonds) and 3.0% (US leveraged loans). The benign default landscape, thus far in 2024, has defied many headwinds that US corporates faced earlier in the year, including elevated policy rates, higher debt interest burdens and bumpy inflation, as well as broader US macro uncertainty.

While there were no actual defaults, looking between the trees, May was not all trouble-free and did produce elevated levels of distressed exchanges. Across US bonds and leveraged loans, seven companies executed distressed exchanges, impacting $8.8bn of HY debt, marking the third largest monthly total on record. Distressed exchanges can come in many shapes and forms. Generally-speaking, creditors and lenders stand adverse to distressed exchanges where material modifications are made to agreed-upon terms of borrowing. However, in challenged situations, they are at times necessary as they can help avert a more costly alternative – value destruction from a disorderly bankruptcy filing. For management teams, distressed exchanges can entail a “right-sizing” of unsustainable debt loads and capital structures, “amend-and-extend” provisions and/or covenant relief, amongst other measures. For lenders, tighter documentation, additional security and collateral, and other credit enhancements are usually provided for any concessions made. While not ideal, distressed exchanges, on some occasions, can provide a path toward long-term viability for a business, and can also help avoid the punitive costs of bankruptcy and value destruction from a disorderly Chapter 11 filing.

From a recovery value standpoint, exchanges, at times, can lead to “less worse” outcomes for troubled situations. According to JP Morgan, “since 2008…the average HY bond recovery rate including distressed transactions is 44.8%, versus 35.3% excluding them (+13%)”. Since 2008, data for 1st-lien loans also paints a similar picture. Per JP Morgan data, “the average loan recovery rate including distressed transactions is 59.2%, or +1.4% versus recoveries excluding them”.

Altogether, May marked a month of mild default activity and year-to-date results have proved to be better-than-expected. US HY corporates have benefited from healthier starting balance sheets, cooperative and improving new issue primary credit markets and a solid US macro growth backdrop. From a portfolio perspective, we maintain an “up-in-quality” bias, with a key focus on credit selection that will allow us to capitalize on an opportune horizon for quality fixed income and attractive yields. In spite of HY corporates fairing a lot better than many expected, spreads in HY do look tight compared to history and other fixed income asset classes. Therefore, we do not think the asset class presents the best risk-adjusted investment in fixed income at the moment. A better way of obtaining exposure to HY issuers is through CLOs which offer a substantial premium over HY spreads at this juncture.