Junk-Loan Defaults Worry Wall Street Investors

Interest payments on the loans float in lockstep with benchmark interest rates set by the Federal Reserve. The higher the central bank raises rates, the tighter the squeeze on companies that borrowed when rates were close to zero.

One sign of concern—a flurry of reports published by investment banks after Fed Chairman Jerome Powell signaled on Aug. 26 his intent to keep rates high to suppress inflation. Wall Street firms sounding the alarm included Bank of America Corp., UBS Group AG and Morgan Stanley, which called the loans a “canary in the credit coal mine.”

“Borrowers are particularly vulnerable to the double whammy of weaker earnings and rising interest rates,” Morgan Stanley strategist Srikanth Sankaran said. That will trigger a wave of credit-rating downgrades and push average loan prices—currently 95 cents on the dollar—below 85 cents, a level breached only during the 2008 financial crisis and the depth of the Covid-19 pandemic, he said.

Falling loan ratings and prices will make it harder for companies to borrow to fund growth or to repay their existing debts. Tighter financing also drags on growth, increasing the risk of the US economy falling into a hard landing. New loan sales have already dropped to $334 billion this year, compared with $532 billion in the first eight months of 2021, according to Leveraged Commentary & Data.

The slowdown is already hurting Wall Street banks that committed to loans earlier in the year—often backing takeovers by private-equity firms—and now need to sell the debt to investors. A syndicate of banks is preparing to unload about $16 billion of debt financing they underwrote for the purchase of Citrix Systems Inc.

by Vista Equity Partners and Evergreen Coast Capital, according to data provider LevFin Insights.

Forecasts for the loan market’s benchmark interest rate—the London interbank offered rate, or Libor—shot up in recent months as the Fed raised rates faster than expected to combat persistent inflation. Traders now expect one-month Libor, which is currently around 2.6%, to hit 4.07% by May 2023, up from the 3.15% they had forecast in April, according to data from Chatham Financial. Expectations are similar for the Secured Overnight Financing Rate, or SOFR, which is slated to replace Libor as the loan market’s benchmark rate next year.

Interest costs for an average company with debt consisting of leveraged loans have increased sharply and will likely continue to rise into next year, according to research by Barclays PLC. The percentage of loans in default will likely rise to roughly 3.25% in mid-2023 from about 1% now, but it could go significantly higher, said Jeff Darfus, a credit analyst at the bank.

Data from a recent Fed survey of loan officers at top banks showed tightening lending standards that a Barclays’s model predicted could cause roughly 4.5% of the loans to be in default a year from now, he said.

That is below the peak default rate of around 7% in 2020. But the pandemic credit crunch was short because the Fed cut interest rates and flooded markets with cash to spur growth. Now the central bank is doing the opposite, and the elevated default rates could last two to three years, analysts say.

Companies at higher risk of default run the gamut from mattress maker Serta Simmons Bedding LLC to software company Avaya Holdings corp.

and restaurant-equipment supplier TriMark USA LLC, according to Fitch.

To be sure, most borrowers don’t have to repay their loans for several years, giving them some financial breathing room. Even among the companies at greatest risk, about 75% of their loans mature in three years or more, according to Fitch.

Regulators have been concerned about the risk that leveraged loans pose to the economy since at least 2015, when former Fed Chairwoman Janet Yellen and others set guidelines meant to limit lending to the riskiest borrowers. The amount of the loans borrowed—primarily to pay for a boom in takeovers by private-equity firms—has since doubled to about $1.4 trillion, Mr. Darfus said.

Fitch puts the figure closer to $1.7 trillion after accounting for midsize companies that aren’t included in widely followed indexes. Other companies have taken out hundreds of billions of dollars of loans in the burgeoning direct-lending market. Those borrowers don’t disclose earnings, making it hard for analysts to estimate how many are in financial difficulty.

As the market has grown, the mutual funds and collateralized loan obligations, or CLOs, that buy most leveraged loans began lending to lower-quality borrowers to boost yields on their investments.

Ironically, investors began piling into loans last year in anticipation of the Fed’s increases because their floating interest rates made them more attractive than bonds, which pay fixed rates. Loan mutual funds and exchange-traded funds took in $71 billion from January 2021 through this April but have experienced $16 billion of outflows since, according to Refinitiv Lipper.

Companies with single-B ratings—one of the lowest rungs in the junk-debt category—now account for about one-quarter of leveraged loans outstanding, compared with 11% in 2010, said Frank Ossino, manager of a leveraged-loan fund at Newfleet Asset Management.

The trend is accelerating. Around twice as many loans received credit-rating downgrades as upgrades in the past three months, the highest multiple since October 2020, according to research by Bank of America. Downgraded companies included eye-care company Bausch & Lomb Corp. and Cream of Wheat maker B&G Foods Inc.

Newfleet began selling single-B loans in February and has since cut them down to 55% of its portfolio from 61%, Mr. Ossino said. Paring back such loans helped the fund deliver better performance than 91% of competing funds ranked by Morningstar Inc. this year, he said.

“They’re the marginal borrower,” Mr. Ossino said. “If their earnings go down and their interest expense goes up, eventually they can’t afford their debt.”

Write to Matt Wirz at matthieu.wirz@wsj.com