The US Federal Reserve is sounding an alarm in its latest Financial Stability Report that business sector debt is reaching critical levels and it may not be long before the weakest companies have trouble servicing massive debt loads.
That is welcome news for restructuring shops that have been in a holding pattern waiting for the next big wave of debt restructurings to hit.
“It’s hard to believe sometimes because nothing seems to turn down any more, but we think there is still a cycle that happens,” said Moelis chief executive Ken Moelis during his firm’s recent earnings call.
Moelis said when the Fed had a plan to keep raising interest rates he thought there would be “a big restructuring cycle”. That hope has faded, but expectations are that the wave is building.
The Fed said in its latest report that sizeable growth in business debt over the past seven years has been characterised by large increases in risky forms of debt extended to firms with poorer credit profiles or that already had elevated levels of debt.
According to the Fed, total business credit stands at US$9.8trn.
“While growth in these riskier forms of debt slowed to zero in late 2016, it has rebounded more recently, with leveraged loan net issuance more than offsetting a modest decline in issuance of high-yield and unrated bonds,” the report said.
The Fed said credit standards for new leveraged loans have deteriorated further over the past six months.
The share of newly issued large loans to corporations with high leverage – those with a ratio of debt-to-Ebitda above six – increased in the second half of last year and the first quarter of this year and now exceeds previous peak levels observed in 2007 and 2014, when underwriting quality was poor, the Fed said.
“I would say the environment has been turning more positive for restructuring probably over the last couple of quarters,” Houlihan Lokey chief executive Scott Lee Beiser told analysts.
“It continues to feel like a relatively healthy environment for restructuring, notwithstanding still we’re in a low default rate and are not experiencing what we’ve seen obviously in different recessionary periods.”
For restructuring firms that credit event could be right around the corner.
Even without a sharp decrease in credit availability, any weakening of economic activity could boost default rates and lead to credit-related contractions among these businesses, the Fed said.
“One of the things about restructuring is, while we may be in the late stages of an economic cycle, we may be in a super early stages of a deteriorating credit cycle,” said PJT Partners CEO Paul Taubman. Therefore, the restructuring opportunity over time is significantly greater than it is today.