Leveraged loan distress rises as software borrowers face refinancing risk

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Leveraged loan distress rises

Highlights

$131 billion (8.3%) of loans in Morningstar's Leveraged Loan Index now trade below 80 cents on the dollar, up from 4.3% at 2023 year-end.
53% of distressed loan volume will mature within three years, intensifying refinancing risk under higher interest rates and tighter lending conditions.
The software sector comprises 32% of distressed loans despite only 12% index weight, with 84% of stressed software borrowers backed by private equity.

Distress levels climb across leveraged loans

As reported by Axios, citing PitchBook, $131 billion of loans in Morningstar's Leveraged Loan Index are trading below 80 cents on the dollar, a common threshold for distress. That represents 8.3% of all outstanding loans by dollar value, up from 4.3% at the end of last year and 3.4% a year earlier.

The leveraged loan market includes debt issued to heavily indebted companies with weaker credit ratings, many of them backed by private equity. Years of higher interest rates and rising economic uncertainty are weighing on these borrowers, particularly those that took on debt when borrowing costs were far lower.

Because most leveraged loans carry floating rates, borrowers face higher interest payments as rates rise. That leaves companies using more of their earnings to service debt, while also raising the cost of refinancing existing loans.

Even so, current distress remains below the levels seen in 2020 and during the 2008 financial crisis. Investors are also increasingly factoring in the risk of liability management exercises, restructuring deals that can help companies avoid bankruptcy but often leave lenders with weaker recoveries.

Software sector stands out as a pressure point

Refinancing risk remains a key concern for the market over the next several years. PitchBook says 53% of distressed loan volume is due to mature within the next three years, increasing the pressure on companies that will need to return to lenders under tougher financing conditions.

The software sector accounts for 32% of distressed loans even though it makes up just 12% of the index, highlighting a sharp concentration of stress. Loan prices for software borrowers fell earlier this year during the so-called SaaSpocalypse, when investors grew more concerned that AI could threaten parts of the sector's business model.

Private equity ownership is adding to that vulnerability. PitchBook says 84% of stressed software companies are backed by private equity, a group that typically carries higher debt loads and has less earnings capacity to absorb the impact of rising interest costs than publicly traded peers.

In our earlier article on rising long-term U.S. borrowing costs, we discussed how Treasury yields above 5% are pushing up mortgage rates and federal interest expenses, tightening financial conditions across the economy. We also noted that with deficits nearing $2 trillion and political gridlock limiting prospects for fiscal restraint, elevated yields can keep pressure on funding markets and increase debt-service burdens for both the public and private sectors.

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