European default-rate survey predicts marginal rise in 2022

Respondents to LCD’s annual European survey predict that corporate debt defaults will rise only marginally by the end of 2022, to less than 1.5%.

Assessing the backdrop to this modest projected increase, survey participants highlight cov-lite structures as well as continuing government support and liquidity that will bolster companies’ balance sheets to some extent, amid interest rates that remain historically low despite hawkish signals from central banks. On the other side of the ledger, participants flag risks that could push up defaults such as the end of furlough schemes, rising inflation, interest-rate hikes, potential supply chain issues and the emergence of any new COVID-19 variants.

Looking at the rolling 12-month default rate of the S&P European Leveraged Loan Index, or ELLI, this was 0.62% (based on principal amount) at the end of December 2021, and on average respondents to the survey predict that it will only reach 1.36% by the end of 2022. Indeed, the default rate in the Index has been falling steadily since its recent high of 2.61% in October 2020 — a level it last reached before that back in May 2017.

The default rate by principal amount will not return to its historical average of 3.22% until at least 2024, according to the survey, while two respondents said that they did not see it returning to that level in the medium term at all. Meanwhile, those responding to the survey said that continued government support for companies along with loose documentation and covenant-lite structures would keep a lid on defaults.

Indeed, the European institutional loan market is now nearly entirely cov-lite, with the structure accounting for 96% of issuance in 2021, according to LCD data. “Rising interest rates might increase defaults if borrowers cannot repay their debt,” said one respondent. “But the proliferation of cov-lite means lots of kicking cans down the road until that happens.”

One investor, however, told LCD that: “Many of the COVID-19-related difficulties have hit sectors already, like we’ve seen with packaging. The companies that may start to struggle are those that have replaced earnings with debt. They are probably quite stressed already, but it will be a few here and there that encounter problems, not a wall of companies.”

Investors commented that the healthy level of refinancing activity seen in 2021 means there will be less urgency to raise money moving forward as companies have already addressed concerns, while the ELLI shows that companies in the Index face only modest refinancing risk at the start of 2022. As of December 2021, maturities in the ELLI do not peak until 2028, when they reach €75.9 billion. This is an improvement on the situation the same time a year ago, when maturities peaked three years earlier, in 2025 (at €57.85 billion).

Risk management

On the downside, survey respondents said that there is a risk to companies when COVID-19 support measures end, as well as inflationary risks relating to raw materials, energy and labor. There could also be continued supply-chain disruption issues, while further COVID-19 variants could emerge. “Inflation is a risk, but it will depend on what central banks do and the impact this has,” one investor told LCD. “The first phase of 2022 likely won’t be very different — it’s when the rate rises actually happen that we will see the impact.”

Indeed, it’s the prospect of high inflation combined with tighter monetary policy that is worrisome, according to LCD’s poll, and will ultimately impact the market’s willingness to refinance highly leveraged credits. Another investor commented that there were credits still out there that had refinanced but remained over-levered, and that the impact of COVID-19 and long-term sector disruption — from changing consumer tastes and technology, for example — was not yet clear.

Sector view

The sectors that LCD's survey participants flagged as being more vulnerable than others most frequently were anything around leisure and hospitality, including entertainment and travel. Retail (albeit non-food) was another commonly mentioned segment, so any company depending on consumer discretionary spending could face challenges. Other, more-industrial, sectors highlighted include chemicals, packaging, automotive and oil and gas companies.

Additionally, one respondent flagged commercial real estate in “large commercially driven cities, particularly those where new ways of working are being employed — for example, see London and the problems faced by Pret a Manger.” And somewhat surprisingly, a few respondents also mentioned healthcare and nursing homes. One explained: “There are some nuances within healthcare companies, while extremely high valuations leading to high leverage could be a weakness in the long term here.”

Of the respondents to LCD's survey, 50% of the €108 billion of funds under management are invested in the loan market via CLO funds. When asked if they were seeing a change in allocations from end-investors into the leveraged loan product, 48% said that they were seeing an increase in interest, while 40% said allocations were stable, and only 12% said that they saw allocations decreasing.

A survey participant who predicted such allocations would decrease attributed this dynamic to an increased focus on direct lending, while another noted that EBITDA adjustments and normalized performance were inhibiting some inflows. However, “more issuers means more diversity,” countered one respondent. “This outweighs the risks of weaker documentation.”

Floating-rate debt

Another reason why market participants say allocations to European loans are increasing is the attractiveness of floating-rate debt amid a rising interest-rate environment. “We will see more investment with rising rates, and it makes sense that people will want to be in floating-rate instruments," said one investor. “The technical support is still there and you can be protected against rate rises. It will therefore be another year of steady carry from loans.”

Indeed, loan investors had a solid stream of income in 2021 with very little volatility, as the ELLI posted a 4.81% return (excluding currency) for the year, with every month of 2021 recording a positive overall reading. The year ended on a long positive streak, with December the 21st-consecutive month to register a positive reading at 0.39% (excluding currency), up from November's 0.24% return.

The 2021 return for the Index was more than 2% above the 2.74% recorded in 2020 and even surpassed 2019's 4.50%, which was the highest such return since 2016 (at 5.73%). The interest return over the last 12 months (excluding currency) was 3.79%, while the market return (excluding currency) — which measures the movement in secondary prices for the ELLI — was 1.02% for the year, which is the highest for the ELLI since 2013.

For now then, default and distress indicators remain low, with some level of support continuing, but the survey responses reflect the fact there are plenty of risks out there. Chief among these, uncertainty remains regarding the prospect of rising rates and how the unprecedented monetary stimulus seen in recent years will be unwound, as well as any future impact from COVID-19.