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Loan default rates creeping back up means rally will be over soon

Loan Default RatesEnlarge GraphLoan default rates keep climbing back towards levels we haven’t seen for the past two years. Default rate is a key metric of credit risk, which is defined as the risk that the counterparty will default on its financial obligations. When default rates increase, it implies that loans are riskier in general and therefore investors will start to demand higher yields for taking on the risk of lending money. When yields go up, prices decrease and that brings down the indices tracking the loan market along with the ETFs following the indices.

The graph above shows the leveraged loan default rates for loans within the S&P LSTA Index, a well-known benchmark for the leveraged loan market with over 800 loans in holdings. The data shows that whether measured by amount outstanding or by number of loans, the default rates have increased to levels last seen in early 2011. This causes a divergence in the market, with yields reaching record lows at the same time that default rates have gone up. The lower yields have boosted prices, but the increasing default rate still contributes downward pressure on the value of the loans.

Eventually the market will reverse and prices will correct to reflect the increased default rates. Additionally, the current wave of repricings has also put downward pressure on prices given loans trading at a premium are likely to be called, so investors are hesitant of bidding up prices beyond the 101-102 limit. Investors in leveraged loan ETFs, such as BKLN and SNLN, should realize that the rally is very close to an end and taking gains is the wisest choice at this point.