Introducing LCD's European Loan Weakest Links: Count falls as credit improves

The ranks of credits in the "Weakest Links" category found in the S&P Global European Leveraged Loan Index, or ELLI, thinned in the second quarter — falling to 9.7% of publicly rated issuers in the index, from a pandemic-era peak of 17.3% in the second quarter of 2020.

Weakest Links are defined as issuers rated B- or lower by S&P Global Ratings, with either a negative credit outlook or on watch negative. While the pandemic resulted in an increase in the number of Weakest Links in Europe, this year's second-quarter number shows considerable credit improvement since COVID-19 shut down markets worldwide in the spring of 2020.

This is LCD's first European analysis of Weakest Links, as measured by the ELLI.

At the end of the second quarter, LCD's loan Weakest Links comprised 26 out of the 278 publicly rated issuers in the ELLI (or 9.7%), down from 43 out of a total 249 publicly rated credits (or 17.3%) after the COVID-19 pandemic roiled European markets in the first two quarters of 2020. This compares with the pre-pandemic level of 10 out of 227 publicly rated issuers at the end of 2019 (or 4.4%).

Looking closer at the data, 70.4% of the current outstanding European Weakest Links earned that designation in 2020, while 14.8% moved into the category in 2019 and 14.8% in 2018. By quarter, the highest percentage of current Weakest Links moved into the category in the second quarter of 2020 — at 29.6% — with the second-highest percentage measured in the first quarter of 2020, at 22.2%. No Weakest Links have been added in 2021. In the first quarter of 2021, there was only one downgrade to B- or lower, and that credit retains a stable outlook. In the second quarter there were two downgrades to B- or lower, but both these credits also have stable outlooks.

The universe of Weakest Links shrinks when more loans exit the cohort — either due to a default, a ratings upgrade, an improvement in outlook or a ratings withdrawal — than join the cohort. In the last quarter, most of the credits moving out the category were revised to a stable outlook (such as IPH Group/Rubix Group International Limited and Flint), although one, namely ASP Unifrax Holdings Inc., was also upgraded at the same time, from CCC+ to B-. According to two separate issuer reports from S&P Global Ratings, Rubix Group's "operating performance continues to improve following relatively resilient 2020 results despite the pandemic," while Unifrax "will benefit from a robust bounce-back in auto production and more gradual recovery in industrial activity during 2021."

The ELLI has seen consistent credit improvement since the beginning of the pandemic, with the downgrade-to-upgrade ratio — based on facility-level ratings — falling from an all-time high of 56x in April 2020 to an 18-month low of 0.69x at the end of June (on a rolling three-month basis). This ratio climbed slightly at the end of July, to 1.2x.

Triple-C category grows

Although there has been credit improvement in terms of upgrades, the reality is that in Europe, the share of credits in the triple-C category of the ELLI rose steadily throughout 2020, from 3% at the end of January to 8.5% at the end of December, and is still higher than January 2020's level, at 7% to the end of July (by par amount outstanding). Single-B minus credits have also increased their share of the index, from 13% at the end of January 2020 to 23% by year-end 2020, retreating slightly by the end of July (20%). However, looking at the constituents of the B- cohort as of July 31 shows that 38% of these names were rated B- at issuance. In other words, the increase in B- outstandings is driven by an increase in new issues with that rating, as well as downgrades.

And although the number of Weakest Links has fallen both in absolute terms and by percentage since the earlier pandemic times, the share of credits in the category with a triple-C rating has increased. At the end of the second quarter, 58% of the Weakest Links were in the triple-C, double-C or single-C rating category, compared to 42% at B-. This compares with 25 (58%) in the B- rating category at the end of the second quarter of 2020, while 18 (42%) were in the triple-C, double-C or single-C rating category.

The Entertainment & Leisure, Services & Leasing, Gaming & Hotels, Consumer Nondurables and Chemicals sectors account for the largest shares of Weakest Links in the ELLI. The sector distribution is similar to that seen in the fourth quarter of 2020, as well as in the initial pandemic peak, although the Chemicals, Computers & Electronics, Services & Leasing, Retail and Television segments were less prominent. But all of these quarters contrast with pre-pandemic times, when far fewer sectors were present in terms of this analysis, with no companies from the Consumer Nondurables, Entertainment & Leisure, Services & Leasing or Gaming & Hotels sectors featuring in the Weakest Links.

Stellar comeback

It has been an unusual 18 months in the leveraged loan market, with the global pandemic causing an extreme market sell-off, resulting in secondary pricing for the ELLI falling off a cliff, with the weighted average bid of the index plummeting to 78.92 on March 24, 2020, while new loan issuance ground to a halt.

But the market has made a stellar comeback since that time. By Dec. 31, 2020, the ELLI had returned to 97.55, only a little over a point off its yearly high of 98.66 seen at the end of January that year. Then, by late February this year, the weighted average bid of the ELLI once again topped its pre-pandemic high. This measure has recently hovered around the pre-pandemic high, but as of Aug. 31 it remained above this level, at 98.82.

Meanwhile, new issuance levels not only recovered, but have since soared, with total European leveraged loan volume coming in at €82.5 billion for first half of 2021 — a tally already higher than full-year 2020 issuance of €64.9 billion, and the highest such first-half issuance since 2007.

Returns in the index were 2.74% (excluding currency) for 2020, which was a strong overall showing considering the dramatic secondary market sell-off seen earlier in the year when COVID-19 first hit Europe. Indeed, the ELLI lost 14.78% in March 2020 — a record monthly decline since its inception in 2002. Year-to-date in 2021, the total return for the index is up, running at 3.63% as of Aug. 31, and has stayed in the black for 17 consecutive months, which is the longest run of positive returns since May 2013. But the ex-currency returns are still down from 2019 when for the full year, European loans gained 4.50%, which was the highest reading since 5.73% in 2016 and significantly higher than the 1.41% recorded in 2018.

Default rate

After years of low levels of distress, the volume of defaults and debt restructurings grew in Europe in 2020. For leveraged loans, the European default rate by issuer count in the ELLI was 4.5% in December that year, and 4.2% in November — down from 4.8% in October, which was the highest such reading since August 2014. Based on the principal amount of loans in the ELLI, the default rate was lower, at 2.57% in December, just behind the 2.60% reading in October, which was the highest on that measure since May 2017. By July this year the default rate by principal amount had fallen to 2.52%, while by issuer count it fell to 1.15%.

One of the reasons for the dramatic fall in default rates is that liquidity has been more readily available to companies in 2020 than many had first thought would be the case. LCD tracked €24.3 billion in European loan revolver drawdowns from March 5 through July 28, 2020. Of these, 66% were in the Consumer Discretionary sector, which felt the sting of the pandemic quickly.

Furthermore, the current default levels are still well below where market participants had previously told LCD they would rise to by the end of 2021. Indeed, investors polled in LCD's annual survey at the end of 2020 predicted that the rolling 12-month European loan default rate by principal amount in the ELLI would rise to 4% by the end of 2021, as European economies grappled with the continued fallout from the COVID-19 pandemic.