Credit market maths seems not to add up

Today’s investors would appear to be better off buying ‘riskier’ debt

Key points Summary Q&A

• Recovery rates on first-lien leveraged loans fell to 44% last year, the lowest since at least 2008.
• René Canezin at Evolution Credit Partners says traders must be assuming defaults near 1% or senior loan spreads are underpriced by about 100 basis points at current recoveries.
• And yet par-weighted defaults were 3.2% for loan-only borrowers in the 12 months to February (4.2% in 2024) and roughly double that when distressed exchanges are included.
• LMEs lift first-lien recoveries by about 9.5 percentage points but 86% of companies that use LMEs still default, restructure or enter bankruptcy within three years.

These summaries are generated by an LLM, but edited by humans.

Something seems off in leveraged loan markets that has nothing to do with underwriting by non-bank lenders or artificial intelligence’s threat to software companies. 

Instead, the oddness results from trends that have been clear for some time – tight spreads in the face of macro risks, liability management exercises (LMEs) that unnaturally dampen default rates, and recovery rates edging downward.

Traditional credit analysis depends on the relationship between defaults, recoveries, and spreads, but the usual balance between the three has arguably disappeared. Bond market maths suggests that in the end, something will have to give.

“Credit spreads only make sense when implied default rates, recoveries, and spreads are in equilibrium,” says René Canezin, founding partner at Evolution Credit Partners. “Today, they’re clearly out of sync.” 

The prompt for growing nervousness among some investors has been a fall in recovery rates in recent times – the share of borrowing retrieved by lenders from companies that default. “As recoveries start to dip below 50, that’s when the warning signs go off,” Canezin says. “When you go below 50, you start to wonder: ‘Am I getting paid for this?’”

 

Recovery rates on first-lien leveraged loans after a default or distressed exchange sank to 44% last year, the lowest since at least 2008, according to research by JP Morgan.

Recoveries have dipped below 50% in only three of the past 18 years, though twice in the past three. Last year’s recovery rate put first-lien loans below the average for high-yield bonds, a theoretically riskier investment.

Some investors, then, are struggling to see much of a case for first-lien debt, particularly compared with riskier – but more substantially rewarded – subordinated loans. 

“With first-lien recoveries down in the 30–40% range, the protection isn’t what it used to be. When mezzanine offers a 300–400 basis point premium, you can’t make that up through slightly better recoveries,” Canezin says. “At that point, the value shifts down the capital structure.”

Tight spreads and low recovery rates could make sense in a world with low defaults. But Canezin argues that current loan spreads assume a default rate significantly lower than levels in recent years. 

At current recovery rates, traders either assume defaults will fall to around 1%, or they have under-priced senior loan spreads by around 100bp, he says. Par-weighted defaults in the 12 months through February were 3.2% for loan-only borrowers, according to JP Morgan research. In 2024, the rate was 4.2%.

Structural change

Might changes in how credit markets function – specifically the rise of LMEs – help explain the discordance? Maybe. 

These out-of-court arrangements that reduce a company’s debt, sometimes at the expense of certain creditors, might see borrowers extend debt maturities or refinance at a discount.

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Research does show they boost recovery rates: lifting overall recoveries by 9.5 percentage points last year for first-lien loans. 

That said, research has also shown that LMEs typically fail to heal troubled companies, with 86% defaulting, restructuring or entering bankruptcy within three years. 

Par-weighted default rates for both leveraged loans and high-yield bonds in the 12 months through February roughly double when including distressed exchanges, according to JP Morgan.

Canezin blames excess investor allocations to senior debt for driving spreads lower. If a manager’s mandate keeps them from investing in instruments lower in the capital stack, the money becomes effectively stuck chasing senior debt, he says. “Liquidity is getting trapped in a bucket, in a label, that might not be the best relative value right now.”

Higher absolute yields potentially ameliorate concerns about diminished spreads if investors feel they’re being adequately compensated overall. Many have used this argument to explain tight bond spreads in the face of macro risks like tariffs.

“Maybe people get less worried about defaults because in addition to the spread it’s a higher-than-usual rate environment,” says Chris Acito, chief executive of Gapstow, an alternative credit investment advisory firm.

“But that doesn’t explain the last year and a half where rates have been coming back in again,” he adds. 

Nor does it fully explain the potentially more attractive risk-reward for subordinated debt. 

Editing by Rob Mannix