Leveraged Finance Sector

Outlook Remains Deteriorating

Jul 12, 2023

Fitch Ratings released a commentary on the European leveraged finance sector stating that the outlook remains deteriorating as default rates will continue to rise.

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The performance of high-yield bond and leveraged loan issuers will continue to diverge. Leveraged loan issuers are likely to default more frequently due to off-market leverage and high volumes of approaching debt maturities in 2025-2026.

Slowing economic growth and rising benchmark rates constrain highly leveraged borrowers’ efforts to maintain credit metrics within their rating sensitivities. Many issuers will have to choose between raising prices to protect operating margins or lowering prices to protect market shares and volumes. A large cohort of secular-growth firms with either a strong global presence or incumbent status domestically is better positioned to maintain profit margins and volumes and to withstand macroeconomic and credit market pressures. However, almost all issuers face higher coupons at refinancing in 2023-2024.

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Active refinancing during 2021 into historically low coupons and flexible terms resulted in stronger liquidity profiles and extended maturities for many issuers. Lower energy prices in Europe and China’s reopening supported better performance in 1Q23. However, resilient growth and corporate pricing power also resulted in persistent inflation with rates continuing to rise in 2H23.

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Defaults by stressed issuers with near-term maturities will increase. We anticipate many of them to engage in liability management exercises to reduce leverage and extend maturities while primary markets remain restrictive. Traditional deleveraging tactics, including cost-cutting and curtailment of capex and acquisitions, will be complemented by opportunistic debt buybacks, debt exchanges, asset sales and amend-and-extend transactions. Some of these transactions are likely to trigger the distressed debt exchange provision in our Corporate Rating Criteria, resulting in downgrades to ‘Restricted Default’ before re-rating upon transaction completion.

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The higher default rate forecast for loans in 2023 reflects a larger share of issuers that have already engaged restructuring advisors. While many remain performing businesses, their off-market leverage and weak liquidity relative to current primary market standards limit their ability to pursue organic deleveraging and market-based liability management.