Pay Attention to the 'Canary in the Coal Mine'

Editor's note: We've avoided a recession so far, but lending is still tight. According to our colleague Mike DiBiase, too many folks are ignoring this potential warning sign – so, we're taking a break from our usual format to cover what he sees coming. In today's Weekend Edition, updated from the January issue of Stansberry's Credit Opportunities, he explains why one looming factor could lead to a spike in defaults... and why investors need to prepare now.

When a canary kicks the bucket, it's time to get out...

In 1911, British miners began taking canaries with them down into coal mines. Because of their faster metabolism, the small birds would show the effects of carbon monoxide before the deadly, odorless gas could harm the miners.

That practice led to the idiom "canary in the coal mine." Today, it means an early warning of danger ahead.

In our Stansberry's Credit Opportunities monthly advisory, my colleague Bill McGilton and I are always on the lookout for a "canary" that will tell us when the credit bubble is getting ready to burst.

This time, the canary might come from leveraged loans...

Leveraged loans are made by banks and other lenders to junk-rated borrowers. Although they trade in the secondary market like corporate bonds, retail investors can't buy them. Only banks and other institutional investors can.

These loans are considered less risky than junk bonds because they typically have adjustable-rate interest payments and are secured by borrowers' assets. They are senior to most junk bonds.

Their adjustable interest rates remove interest-rate risk. And the security backing the loans increases the chances of a higher recovery in the event of a default. But leveraged loans have a downside...

When rates are elevated – like they are today – it's harder for companies to afford the interest payments. And heading into a slowing economy, these loans will be much more difficult to refinance.

That's why we expect leveraged-loan defaults to rise before defaults spike in junk bonds. In other words, a spike in leveraged-loan defaults could be our canary in the coal mine.

According to credit-ratings agency Fitch, the average default rate for leveraged loans over the past 15 years was 2.5%. Thanks to the post-pandemic stimulus, that rate dropped close to all-time lows of less than 1% in 2021.

Rising interest rates, inflation, and a slowing economy started to push the default rate back up toward its historical average last year. And it's headed higher...

Fitch estimates that leveraged-loan defaults will hit 3.5% to 4.5% by 2024. We think they're headed much higher than that.

Around $27 billion in leveraged loans defaulted last year. That's around three times higher than the $9.8 billion that defaulted in 2021, according to Fitch.

Some investors are already running for the exits...

The Blackstone Private Credit Fund ("BCRED") is one of the world's largest direct-lending funds. It owns a portfolio of $50 billion in leveraged loans.

Despite 94% of BCRED's loans being secured – all at floating rates, with zero defaults – many investors want their money back before the trouble starts. BCRED hit its quarterly redemption limit in the quarter ended November 30, meaning investors demanded their money back on at least 5% of outstanding shares.

We predict leveraged-loan default rates will soar, beginning later this year. The leveraged-loan market will dry up. That would shut off an important source of corporate liquidity and trigger more corporate-bond defaults.

And that's not just speculation. The canary isn't looking so good these days...

Leveraged loans are getting hit with a wave of credit downgrades. In the fourth quarter of 2022, downgrades of these floating-rate loans hit their highest level in five years. Investment bank Morgan Stanley (MS) says the downgrade wave is just getting started.

Remember, downgrades precede defaults. So we expect to see a wave of leveraged-loan defaults next. The default wave will spread to other types of loans, too... from credit cards to auto loans, business loans, and bonds.

The conditions for the financial storm are getting worse. Inflation remains stubbornly high. The Federal Reserve is hinting that interest rates won't be on pause for long. And credit continues to get tighter...

We can see this in the Fed's latest surveys of bank loan officers. They are getting concerned and lowering their risk...

More and more of them are saying they are "tightening," meaning they are making loans harder to get, shrinking loan sizes, and offering terms that are more favorable to lenders.

And they did so across all types of loans... including loans to big and small businesses as well as credit-card loans to consumers. Take a look...

Excluding the brief period following the pandemic, we haven't seen credit this tight since right before the last financial crisis. All of these signs tell us the U.S. economy is in trouble.

But for now, investors remain oblivious.

The stock market is up nearly 15% this year. And the largest high-yield ("junk") exchange-traded funds are each up nearly 5%.

Stocks and bonds were already expensive at the start of the year. Investors continue chasing up prices, making them even more expensive. They're like miners heading deep underground... without a canary by their side.

Don't be one of them.

Good investing,

Mike DiBiase

Editor's note: Businesses are going bankrupt at the fastest pace since the last financial crisis. Earlier this year, seven companies went belly-up in just 48 hours – the most in any two-day period since at least 2008. It's the start of a wave that could wipe out unsuspecting investors... But for years, Mike has been waiting for this exact moment.

That's because the cascade of bankruptcies also opens the door for tremendous profits – with gains that have legal protections – if you know what you're doing. Get the full story here.