Rising credit defaults due to spike in LMEs

Rising defaults in the credit markets over the past year have resulted in an increase in the use of liability management exercises (LMEs).

According to a new white paper by Davidson Kempner Capital Management, the higher use of LMEs has resulted in distressed exchanges reaching their highest level since the global financial crisis.

This trend was driven by corporate borrowers and sponsors embracing LMEs to address strained liquidity and difficult refinancings as the base rate rose.

Davidson Kempner noted that the prevalence of LMEs has led to a much higher default rate for leveraged loans than for high yield bonds.

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“The dispersion in recovery rates underscores the need to be highly selective about investing in companies that might pursue LMEs,” the white paper said.

“Credit underwriting needs to factor in how a company is likely to perform, what the documents will allow and the various possible outcomes under different process scenarios.

“Sometimes the best entry point can be after an LME, when the process risk is mitigated but the taint of the transaction continues to weigh on pricing.”

The white paper – titled ‘The Tides of Credit: Opportunity in Dispersion’ – added that opportunity set borne out of these dynamics could be massive. The total amounts outstanding for leveraged loans, high yield bonds and direct lending stood at approximately $3.3tn (£2.59tn) by March 2024, representing a 260 per cent growth since 2007.

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Davidson Kempner said that capital structures across both public and private credit markets will eventually be forced to confront the current higher rate environment as it becomes the new normal.

“We believe we are in the first wave of a multi-year corporate credit cycle as many companies have yet to fully adjust to the higher cost of capital,” said the white paper.

“During this multi-year cycle, we expect the elevated dispersion in pricing and recoveries across the credit spectrum to continue. We believe the next few years will be very active in both primary and secondary credit markets, especially for experienced credit investors.”

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