Whenever the underlying economy experiences a downturn, risks in the financial system multiply as pressure builds on the weakest links in the chain.

Roughly 14 years ago, recessionary pressures in the economy ultimately triggered the 2007-2008 financial crisis as residential homeowners struggled to meet their debt obligations. In that extreme case, weakness in the real estate sector acted like a contagion and contributed to a crisis of confidence in the broader financial industry.

As most will recall, it was the unraveling of some complex loan instruments—known as collateralized debt obligations (CDOs)—that many now attribute to the first spark in that massive financial meltdown.

Looking ahead into 2023 and beyond, few experts expect a redo of that massive fiasco anytime soon. That’s primarily because lending standards were tightened in the wake of the 2007-2008 crisis, which theoretically reduces the ongoing likelihood of defaults in the residential real estate sector.

However, that certainly doesn’t mean every risk in the system has been completely mitigated.

So with the risk of a global recession increasing in likelihood, many are now wondering about the weakest links in today’s financial system. And one of the areas of greatest concern appears to be so-called leveraged loans in the corporate sector.

The ABCs of leveraged loans

In the world of consumer finance, borrowers with poor credit histories typically don’t qualify for traditional loans. As a result, this group of borrowers typically takes out subprime loans, which have less favorable rates and terms as compared to normal loans.

That same concept also applies to the corporate sector, where companies with poor credit, or too much debt, often lean on leveraged loans. Due to the increased risk associated with such borrowers, leveraged loans are associated with higher interest rates and less favorable terms.

They are often packaged and syndicated by the financial industry using financial instruments known as collateralized loan obligations (CLOs). Much like subprime mortgages can be packaged as CDOs.

Leveraged loans are typically labeled as such according to the creditworthiness of the borrower, or by the interest rate associated with the loan.

For example, if a credit agency rates the loan as below investment grade, that would qualify as a leveraged loan. On the other hand, a loan may also be labeled as leveraged if the rate on the loan is especially high. Typically this results in a higher spread for the lending syndicate to compensate for increased risk.

When it comes to credit rates, leveraged loans fall in the non-investment grade category.

Based on the increased risk inherent in leveraged loans, one can see why this niche might be of particular interest amidst an economic downturn.

As the economy loses steam, it’s these overleveraged companies with poor credit histories, that are paying above-market interest rates, which typically feel the most pressure.

Where things stand today

After many years of accommodating the economy with a dovish approach, the U.S. central bank has been raising benchmark interest rates aggressively since early last year. Today, benchmark interest rates in the U.S. are at a 15-year high.

Obviously, that means companies and individuals that need to refinance their outstanding loans are doing so at less favorable terms. In general, that means financing costs are going up across the board.

There’s a breaking point for everything, and as interest rates have risen, some companies have found it increasingly difficult to service their loans. Especially those loans with floating rates, which automatically increase in lockstep with rising benchmark rates.

As highlighted below, the amount of so-called corporate distressed debt in the U.S. has been rising steadily since the spring of 2022. Companies with distressed debt are generally hampered by unstable capital structures and are usually in bankruptcy or default, or on the cusp of it.

While the above demonstrates that levels of distressed debt are rising, the situation is by no means dire, at least not yet. In historical context, distressed debt levels in the U.S. are still below long-term averages.

Today, the total value of outstanding leveraged loans in the U.S. is estimated at roughly $1.4 trillion. That’s a sizable chunk of capital tied up in higher-risk loans. Back in 2011, in the wake of the financial crisis, the total outstanding value of leveraged loans in the U.S. was closer to $500 billion.

However, the default rate for the leveraged loan sector remains under 2%. For reference, that same rate jumped to roughly 12% in the aftermath of the financial crisis, according to data compiled by the Federal Reserve.

The credit rating agency S&P Global is currently forecasting that the default rate on leveraged loans will rise to roughly 4% in 2023. However, that’s more of a base-case scenario. Some of the worst-case outlooks indicate that the default rate on leveraged loans in the U.S. could jump as high as 9% in 2023 or 2024.

While it’s difficult to predict which scenario will play out, the financial industry is already bracing for trouble in 2023. Banks with the most exposure to the leveraged loan niche have increased loan loss provisions substantially in recent quarters. These are the funds set aside to cover defaults.

The severity of the forthcoming recession, assuming one does in fact materialize, will heavily influence the default rate for leveraged loans in the coming year.

Paul Singer of the Elliot Management Group recently told Yahoo! Finance that the global financial system is “vastly over-leveraged” at this time, suggesting that a severe recession could have an unpredictable, and potentially calamitous, impact on the economy.

The main concern is that a severe recession would sharply compress corporate earnings, and in turn hinder corporate liquidity. Such conditions are suboptimal for the repayment of loans—especially those held by lower-tier borrowers.

As such, investors and traders may be well advised to monitor the health of the leveraged loan industry in the coming months, as this niche of the financial system could very well act as the canary in the coal mine. If a severe recession does develop, that could put the bloated leveraged loan sector under extraordinary pressure.

To follow everything moving the markets on a daily basis—including corporate defaults and bankruptcies—monitor tastylive, weekdays from 7 a.m. to 4 p.m. CDT.

Sage Anderson is a pseudonym. He’s an experienced trader of equity derivatives and has managed volatility-based portfolios as a former prop trading firm employee. He’s not an employee of Luckbox, tastylive or any affiliated companies. Readers can direct questions about this blog or other trading-related subjects, to support@luckboxmagazine.com.