As we near the end of what has been by any account an unprecedented year, LCD has expanded its quarterly loan default survey to gauge how leveraged finance pros are gearing up for 2021, and what challenges they expect to face as markets and economies worldwide attempt to further rebound from the coronavirus pandemic.
The results of the wide-ranging U.S. Leveraged Loan Survey are detailed below. Some of the headlines:
- The U.S. leveraged loan default rate is expected to end 2021 at 4.76% (it is currently 3.89%).
- The default rate peak is expected at less than 6%, but the default cycle could extend for 1-2 years.
- Credit quality tops the list of concerns for leveraged loans in 2021.
- Balance sheet maneuvers, specifically covenant waivers and extensions, are expected to remain elevated.
- Access our complimentary infographic summarizing the results.
What a year ...
In a year that saw the fastest-ever collapse of the global financial markets, the $1.2 trillion asset class of U.S. leveraged loans, in particular, was hit from all sides.
Ever at the behest of rates, retail investors fled the asset class en masse as Treasury yields in March plunged to new lows and volatility spiked to all-time highs.
Demand from CLO investors, by far the largest buyer of leveraged loans, also dried up. Amid record downgrades and plunging loan prices, CLOs failed an increasing number of coverage tests that are designed to monitor collateral deterioration.
The Federal Reserve’s near-zero rate policy, which could remain in place through 2023, and limited Central Bank support, in comparison to a rivaling high-yield bond asset class, makes the fourth-quarter recovery in the U.S. leveraged loan market all the more impressive. Year-to-date returns were 2.79% at the Dec. 16 close, from year-to-date losses of 20.07% on March 23.
As the rollercoaster of 2020 nears its conclusion, questions abound for the leveraged finance markets heading into 2021. Where are defaults headed? Will COVID-related bankruptcies remain a concern? Which sectors will outperform?
With that in mind, LCD’s new Leveraged Loan Survey, launched on Dec. 7, polled a mix of buy-side, sell-side and advisory firms for their point of view on the upcoming 12 months. In light of the fast-moving pace of the markets in 2020, the survey, from polling to the release of findings, was conducted within a two-week period.
A top-ten performer in the S&P/LSTA Leveraged Loan Index in the year to date, Technology is expected to lead the way through the first half of 2021, garnering 17% of the votes in favor of the sector outperforming others in the loan market. Tech, though, was narrowly followed by Health Care, with 16% of the responses.
At 15.3%, Technology is the largest sector in the $1.2 trillion loan market, as referenced by the S&P/LSTA Leveraged Loan Index at the end of November. Among the more troubled, Oil & Gas and Retail, by comparison, each constitute a slim 3%, while Leisure is just 4.3% of the market.
Breaking the responses down further, with the November rally leaving those underinvested in pandemic-exposed and triple-C rated loans underperforming their benchmarks, roughly 17% of buy-side respondents expect the consumer discretionary sector to outperform in the loan market in the next six months, as do 10% of sell-side respondents.
Buoyed by liquidity from central banks, the credit markets staved off the more painful default wave initially feared as companies sought breathing room on loan terms in record numbers in 2020, and as previously solvent entities — hit hard by the pandemic — locked in liquidity while they could.
But the now-derailed decade-long economic expansion, and accommodative Fed-policy that allowed companies to load up on cheap debt, has brought about a significant deterioration in the overall credit quality of the leveraged loan market.
For the market participants polled by LCD, credit quality — over default activity — was cited as the main concern for leveraged loans in 2021, accounting for 26% of the responses. COVID-related lockdowns came in second place, at 19%, with documentation/terms and loopholes placing third, at 15%.
Default and restructuring activity came in fourth, at 13%.
Looking back at what was one of the weakest earnings quarters for corporate America on the back of the damage caused by global lockdowns, and months-long closures of non-essential businesses, public companies within the S&P/LSTA Leveraged Loan Index, on average, reported a 23% year-over-year decline in EBITDA in the second quarter. By the third quarter an eye-watering 32% of public filers in the index carried leverage of greater than 7x, double the proportion a year earlier, and up from 14% at the cycle low for leverage, in the fourth quarter of 2018.
Meanwhile, the post-COVID-19 downgrade cycle further weakened the ratings quality mix of the leveraged loan market, with the share of index loans rated B- or lower (excluding defaulted credits) at the corporate level swelling to 33% in November, compared to just 12% five years’ previous. CCC or lower loans, at the May peak, made up 12% of the index, compared to just 3% in May 2015.
Slightly more than a third of respondents (35%) think 10-Year U.S. Treasury Yields will be between 1% and 1.49% at year-end 2021, from 0.92% as of Dec. 15. This suggests some participants are expecting a modest increase even as the market awaits more clarity on the timing of the Fed winding down its asset purchase program.
Survey respondents expect loan defaults will rise over the next 12 months, from its current rate of 3.89%, though only 29% say the peak will be at 6% or above. This marks a significant improvement from the throes of the market crash in March, when Street expectations generally called for peak default rate of 7-8%.
Market participants, on average, see the default rate of leveraged loans ending 2021 at 4.76%.
Against the backdrop of easing EBITDA declines in the third quarter of 2020, and the Federal Reserve’s efforts to shore up liquidity — which helped normalize funding markets, stem downgrade activity and curtail overall distress levels — a majority (57%) of respondents expect the cycle of above-average default rates to end in 1-2 years’ time.
With defaults, recoveries and credit deterioration still firmly on investors’ radar, LCD asked market participants what forms of capital structure renegotiations they expect to see in 2021. The easy winner was amendment and covenant relief activity, at 45%. That was followed by debt-for-debt exchanges, at 18%, and pre-packaged bankruptcy, at 17%.
For questions on LCD’s Leveraged Loan Survey, please contact Rachelle Kakouris, Director, LCD Research
Subscribe to LCD’s complimentary newsletter
To see additional 2021 outlooks for the leveraged finance markets
Request a demo of LCD