May 15, 2024 - Discussions about default rates are becoming more relevant as the reality of a higher-for-longer interest rate environment sets in. They often manifest in headlines or press interviews that may appear inconsistent or raise eyebrows. Given this disconnect, it’s helpful to understand the methodologies used by the various ratings agencies and index providers to calculate default rates, as they not only may differ, but also potentially create misleading conclusions.
This is particularly true in the case of private corporate credit (i.e., leveraged corporate loans made by nonbanks). Private corporate credit does not benefit from a market-standard sample that can be used to draw meaningful conclusions. This is due to a lack of public ratings and variability in the number of private corporate credit loans that are privately rated, receive credit estimates by a ratings agency or are otherwise tracked. Moreover, as is the case with broadly syndicated loans, the types of defaults included in the private corporate credit loan default analysis can significantly impact the default rate.
Below, we look at the published default rates for Fitch, S&P, Proskauer, Lincoln International and KBRA DLD’s private corporate credit universes and their respective approaches to their analysis. (Note: Fitch, S&P and KBRA calculate their default rates on a trailing-12-month (TTM) basis updated monthly, and, as such, they reflect the size of the universe 12 months prior rather than the current size. Proskauer and Lincoln consider defaults on a point-in-time, quarterly basis (i.e., defaults occurring with a given quarter).)
Fitch
Fitch’s universe includes about 300 middle market loans (borrowers with less than $100M in EBITDA) for which it provides private ratings. These loans are largely direct lending term loans. Additionally, Fitch notes that the defaults in the portfolio are selective (conversion of interest to payment-in-kind (PIK)/deferred payment) and conventional (missed payment). Covenant defaults are excluded. The default rate for this universe was about 3.7% in 2023 by issuer count, up from 2.9% in 2022.
Standard & Poor’s
S&P’s proxy universe is based on credit estimates rather than private ratings and is larger than Fitch’s at about 2,800 borrowers. As with Fitch’s rate, this calculation includes selective defaults (any measure taken by the borrower/out-of-court restructuring for which the lender is not adequately compensated, including PIK conversion/deferred payment, amend-to-extend, scheduled amortization waiver and covenant breach) and conventional (missed payment, bankruptcy filing) defaults. S&P calculates the default rate at 5.37% in 2023 by issuer count, up from 3.07% in 2022. Excluding selective defaults, the default rate drops significantly to 0.87% in 2023 and 0.54% in 2022.
Proskauer
Proskauer’s Private Credit Default Index tracks about 980 senior secured and unitranche loans across all major industries with EBITDA sometimes exceeding $1 billion. It includes conventional defaults (missed payment and bankruptcy) and selective defaults (amendments in anticipation of a default, covenant breaches and loans otherwise in default if the default is material and expected to continue for more than 30 days). The rate was 1.6% in 4Q23 by issuer count, down from 2.06% in 4Q22.
Lincoln International
Lincoln International observes private corporate credit loan defaults through its Senior Debt Index, which tracks more than 500 middle market, direct lending loans. It defines defaults as covenant breaches only. The default rate was 3.4% in 4Q23 weighted by value, down from 4.2% in 4Q22.
KBRA DLD
KBRA DLD’s Index contains 2,400 companies financed by direct lending loans (i.e., senior secured term loans of at least $20 million that exclude characteristics of BSL loans). The calculation includes conventional defaults (e.g., missed payments and bankruptcies) and certain selective defaults (e.g., distressed debt exchanges and/or restructurings) while excluding other selective defaults (e.g., PIK/deferred payments and technical defaults such as covenant breaches). The default rate was 2.3% in 2023 based on issuer count. (KBRA does not track data prior to 2023.)
A key takeaway is that the default rate is dependent on how inclusive the default set is. Including selective defaults – covenant defaults in particular – is likely to give the appearance of elevated risk in private credit deals. A larger headline number belies the fact that the private credit market still relies on covenants whereas the broadly syndicated market is effectively covenant-lite. This distinction in market structure creates more opportunities for defaults in private credit if technical defaults are included.
On the flip side, looking exclusively at conventional defaults tells a different story (as evidenced in the S&P results). The lower percentage of defaults derived from taking only conventional defaults into account is a function of one of the attributes of private credit: smaller lender groups that can be nimbler in supporting a stressed company resulting in consensual deals that help to avoid liquidity crunches or bankruptcy. Bottom line, a default rate is only useful if properly understood.
