Currently, leveraged loan defaults are near zero. I believe 2022 cumulative defaults have totaled about 0.6% as of this week. The long term average is around 3%.
The big question is as rates rise, what will happen to defaults? Blackstone’s publicly traded leveraged lending BDC gave a very specific answer as to how interest coverage will trend at different levels of interest rates:
…if LIBOR gets to 4.3%. So today, we’re at, what, 2.92%. And let’s just say we go past the [current futures] curve which is 3.9%. And we’re at 4.3%. And we stay there for a 12-month period.
The percentage of our companies that have less than one-time interest coverage is 4.3%. And if you go up [sic] from 4.3% and you go north of 5% that ticks up a little bit, but not much more from there.
BXSL 2Q22 Earnings Transcript
One has to make their own assumptions on interest rates, default rates, and recovery rates (as well as timing, etc.) – but these numbers help think about it. If all of those names below 1x interest coverage default, and higher rates shake out more weak links, perhaps the BX portfolio gets a default rate of ~5%. Typical recovery rates are around 65% for first lien leveraged loans – but to make it simple and assume 50% – you would get to a 3.25% loss rate if it all happened in one year (not reality). This leveraged lending vehicle is about 43% equity – so a 3.25% loss on total assets is about an 8% loss to the equity (3.25/43). Not ideal, but would consume near one year of interest income. Also not a draconian scenario.
As always, the elephant in the room is what may happen on top of expectations, which is not envisioned today. And that we will likely never know until it happens.
Disclosure: My family owns shares in BXSL, this is not investment advice. Do your own work.