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A wrecking ball could hit leveraged loans if the Fed keeps rates high

Many companies that took out of floating-rate debt in the roughly $1.5 trillion U.S. leveraged loan market could face significant distress next year if the Federal Reserve keeps its policy rate high, according to Oaktree Capital Management.

“On the surface, many companies in the U.S. appear to be weathering the sea change in interest rates surprisingly well,” a team led by Bruce Karsh, co-chairman and chief investment officer at Oaktree, wrote in a new client note.

“But storm clouds are beginning to emerge as elevated interest rates are making it more challenging for companies to service their floating-rate debt.”

Leveraged loans are a type of “speculative-grade” floating-rate debt, but with rates only resetting several times each year, providing some wiggle room for unhedged borrowers from the Federal Resrves’s rate hikes since 2022.

However, about 62% of companies in the B- ratings category of the U.S. loan market would see their ability to pay interest on their debts fall below a key 1.0x coverage ratio, should the Fed’s policy rate remain unchanged next year at its current 5.25%-5.5% range, according to Moody’s Investors Service.

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