PitchBook's new analysis puts the value of loans trading below 80 cents on the dollar in Morningstar's Leveraged Loan Index at $131 billion. PitchBook identifies that price as a widely used threshold for distress. The distressed amount is the largest since May 2020, during the recovery from the pandemic market sell-off. Distressed loans account for 8.3% of outstanding loans by dollar value, compared with 4.3% at the end of last year and 3.4% a year ago. However, distress remains substantially below levels reached in 2020 and during the 2008 financial crisis.
Investors use the leveraged loan market to trade debt issued to companies with substantial borrowing and poor credit ratings. Private equity typically backs these borrowers. Rising distress signals that more heavily indebted companies face a risk of default when economic conditions weaken. Several years of elevated interest rates, including an increase this year, and greater economic uncertainty are putting pressure on borrowers. Barclays credit strategist Corry Short wrote in a note this week that many borrowers accumulated debt when zero interest rates made borrowing inexpensive.
Floating interest rates apply to most leveraged loans, so borrowers must pay more when rates rise. Marina Lukatsky, PitchBook's global head of research, credit and U.S. private equity, said companies have needed to allocate more earnings to interest payments as rates increased. Refinancing existing loans is also becoming more expensive. More companies are using restructuring transactions known as liability management exercises to avoid bankruptcy. The Barclays note says these transactions can produce poor outcomes for lenders, and investors are incorporating that risk into prices.
PitchBook says 53% of distressed loan volume matures within the next three years, meaning the borrowers will need to refinance. Lukatsky described the refinancing requirement as a significant risk. Conditions could deteriorate further.
Some heavily indebted companies also face threats to the survival of their business models, particularly in software. Software accounts for 32% of distressed loans despite representing only 12% of the index. Software loan prices fell sharply earlier this year as investors grew concerned that artificial intelligence could threaten the industry's survival. Those concerns continue to influence credit markets even though stock markets appear to have moved beyond them.
PitchBook says private equity backs 84% of stressed software companies. These businesses generally have greater debt and smaller earnings cushions against interest rate increases than publicly traded software companies. Companies that borrowed heavily while financing was inexpensive are now experiencing the consequences.
Distressed Loans Hit $131 Billion as SaaSpocalypse Risks Loom
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Summary
On-chain analysis reveals distressed loans have surged to $131 billion, the highest since May 2020. These loans, often backed by private equity, now make up 8.3% of outstanding loans, up from 4.3% at year-end 2022. On-chain data shows 32% of distressed loans are in the software sector, which accounts for just 12% of the index. Rising rates and economic uncertainty are pushing many borrowers toward refinancing within three years, raising concerns about worsening credit conditions.
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