Collateralized Loan Obligations (CLOs) have a structural covenant limiting their holdings of CCC-rated (or below) loans to typically 7.5% of the portfolio. As more loans are downgraded past this threshold, managers are forced to sell, even if they believe in the credit's long-term value. This creates artificial selling pressure and price distortions.
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A slowing economy leads rating agencies to downgrade loans. Since Collateralized Loan Obligations (CLOs) have strict limits on lower-rated debt, they become forced sellers. This flood of supply depresses prices further, creating a negative feedback loop that harms even fundamentally sound but downgraded assets.
Default rates are not uniform. High-yield bonds are low due to a 2020 "cleansing." Leveraged loans show elevated defaults due to higher rates. Private credit defaults are masked but may be as high as 6%, indicated by "bad PIK" amendments, suggesting hidden stress.
The classic distressed debt strategy is broken. Market dislocation windows are now incredibly narrow, often lasting just days. Furthermore, low interest rates for the past decade eliminated the ability to earn meaningful carry on discounted debt. This has forced distressed funds to rebrand as 'capital solutions' and focus on private, structured deals.
The credit market appears healthy based on tight average spreads, but this is misleading. A strong top 90% of the market pulls the average down, while the bottom 10% faces severe distress, with loans "dropping like a stone." The weight of prolonged high borrowing costs is creating a clear divide between healthy and struggling companies.
The increase in Payment-In-Kind (PIK) debt to 15-25% of BDC portfolios is not a sign of innovative structuring. Instead, it often results from "amend and extend" processes where weakened companies can no longer afford cash interest payments. This "zombification" signals underlying credit deterioration.
In large loan portfolios, defaults are not evenly distributed. As seen in a student loan example, the vast majority (90%) of defaults can originate from a specific sub-segment, like for-profit schools, and occur within a predictable timeframe, such as the first 18 months.
Aegon's Global Head of Leverage Finance, Jim Schaefer, shares a critical heuristic: once a leveraged loan's price falls below the 80-cent mark, it has a high probability of entering a formal restructuring. This price level acts as a key warning indicator for investors, signaling imminent and severe distress.
The CCC-rated segment of the high-yield market should not be treated as a simple down-in-quality allocation. Instead, it's a "stock picker's" environment where opportunities are found in specific, idiosyncratic situations with high conviction, such as a turnaround story or a mispriced part of a company's capital structure.
The modern high-yield market is structurally different from its past. It's now composed of higher-quality issuers and has a shorter duration profile. While this limits potential upside returns compared to historical cycles, it also provides a cushion, capping the potential downside risk for investors.
Despite higher spreads in the loan market, high-yield bonds are currently seen as a more stable investment. Leveraged loans face risks from LME activity, higher defaults, and investor outflows as the Fed cuts rates (reducing their floating-rate appeal). Fixed-rate high-yield bonds are more insulated from these specific pressures.