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2021 Outlook: European distressed debt levels may rise as support measures ease

The level of corporate defaults and debt restructurings could stay elevated in 2021, or even rise, as European governments turn off the life-support measures that have kept many businesses alive in 2020, a number of debt market participants predict.

2020 will go down in history as the year that broke the decade-long growth cycle, as the coronavirus pandemic disrupted global economies. After years of low levels of distress, the volume of defaults and debt restructurings by total debt across the European leveraged finance market (including loans and bonds) jumped to an 11-year high of €36.85 billion as of Dec. 4, 2020, from €13.8 billion in 2019 and a mere €5.6 billion in 2018, according to LCD.

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For leveraged loans, the European default rate by issuer count was 4.2% in November — down from 4.8% in October, which was the highest such reading since August 2014. Based on principal amount of loans in the European Leveraged Loan Index, or ELLI, the default rate is lower, at 2.4%, just behind the 2.6% reading in October, which was the highest since May 2017.

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In the face of rising defaults this year, unprecedented central bank liquidity and government relief actions have kept the amount of companies in distress below expectations, many analysts say. "In spite of a tumultuous year, default rates in European [high-yield bonds] and leveraged loans are relatively benign," write analysts at Barclays Credit Research in a report titled 2021 Default Outlook. "Much of the lower rate can be attributed to the unprecedented scale of stimulus by governments and liquidity by central banks, companies’ own initiatives and ability to reduce costs, access to capital markets largely being open and support by sponsors, particularly in the case of leveraged loan issuers."

Indeed, huge amounts of cash have been made available in response to government-enforced lockdowns to curb the spread of COVID-19. In addition to low interest rates and the European Central Bank's asset purchase program, governments in Europe have also introduced country-specific measures that businesses can apply for, including job-retention schemes, government funding/loan schemes, tax relief, and relaxing directors' obligations for mandatory insolvency filing.

Default outlook predictions vary, with S&P Global Ratings projecting the European speculative-grade default rate will increase to roughly 8% by September 2021 (this is one of the highest estimates for the default rate). Moody's predicts a 6% peak in Q1'21, before the default rate drops to 4%, while J.P. Morgan Europe Credit Research predicts a peak of 4% in the near term, with the default rate then dropping to 2% for full year 2021 for European high-yield.

Drivers to the upside
Life support: In November, ECB President Christine Lagarde signaled that the bank could expand its pandemic emergency purchase programme (PEPP), which has bought more than €640 billion of bonds, and its targeted longer-term refinancing operations (TLTRO) scheme, which has lent almost €1.5 trillion to banks at rates as low as negative 1%. While the PEPP currently runs to June 2021, most analysts expect an extension until the end of next year, adding as much as €500 billion. There is also hope that some countries would extend certain support schemes from the end of March 2021 to continue supporting businesses.

Raising debt (and equity): This year has already shown that even some of the more challenged borrowers, such as CMA CGM, Aston Martin, Maxeda, Tereos and Boparan, have been able to tap lenders to raise financing in a risk-on and technically strong high-yield bond market. With the PEPP to stay in place until at least June 2021 and amid other dovish monetary policy, the technical backdrop will remain supportive for bonds and loans as demand for investing in high-yield credits is expected to outstrip supply. Raising capital in equity markets in combination with debt — as demonstrated by Rolls-Royce in October, or planned by McLaren — may also prove a favorable route for European firms. Moreover, private equity sponsors have broadly shown support for their portfolio companies, digging deep into their pockets to help refinance or restructure businesses. Lowell is a case in point here, as sponsor Permira injected €600 million as part of the firm’s refinancing, while Selecta obtained €125 million from owner KKR.

Fundamentals: Some analysts argue that fundamental risks have already peaked, and that corporates have cautiously and efficiently addressed balance sheet concerns. Moreover, the European economy is set to return to growth in 2021, from this year’s contractions, with the official European Commission euro area economy forecast currently at 4.2% growth for 2021, following a contraction of more than 7% this year. Earnings are therefore set to gradually recover in 2021.

Ratings distribution: Although the proportion of European leveraged loans rated in the CCC categories has risen, the picture in high-yield bonds remains more stable. Barclays notes in a research report that the level of bonds in the market rated CCC or lower has remained unchanged this year, at 8%. What’s more, downgrades have generally slowed in both the loan and bond markets, according to LCD and credit research reports.

Timing of full COVID-19 immunization: With announcements on vaccine rollouts expected in late December for some European countries and the U.K. already beginning its program, there is real hope that business activity can return to normal in the first half of 2021, with the potential for a major rush by consumers to return to travel and leisure activities that they have missed out on for many months.

Rules and regulations: Three countries in Europe — namely the U.K., Germany and the Netherlands — have introduced new restructuring reforms, giving borrowers and creditors in these jurisdictions a greater set of tools to choose from to more efficiently implement deals such as debt-for-equity swaps. The U.K.’s new Restructuring Plan procedure already came into effect this summer, and was successfully taken up by PizzaExpress as the first high-yield borrower to use the process. Meanwhile, the reforms for Germany and the Netherlands will become effective next year. Germany will benefit from a ground-breaking pre-insolvency procedure for the first time in history, offering a "scheme" similar to that in the U.K. The Netherlands also took steps to legislate for the introduction of a new restructuring tool, which has similarities to the English scheme of arrangement and company voluntary arrangements, as well as the U.S. Chapter 11 procedures.

Drivers to the downside
Life support: Amid a second wave of COVID-19 cases, a number of jurisdictions in Europe have agreed to extend the majority of their temporary support measures into the spring or summer of 2021, according to a client briefing from Freshfields. However, many debt market analysts say they are concerned that once these support actions run out, the amount of insolvencies and restructurings could rise. In particular, the current relaxation of mandatory insolvency filing obligations in some countries, such as Germany, could lead to a surge in defaults. "It is unclear how long these measures will, or indeed can, remain in place, and what will happen as support is removed from the various countries and many businesses face increased debt loads. Many anticipate a marked increase in restructurings and insolvencies through Q4 2020, perhaps peaking in H1 2021," said Richard Tett, partner at Freshfields Bruckhaus Deringer (writing in August).

"Insolvencies and defaults among European corporates will spring higher in 2021 as governments wind down substantial support packages and economic activity starts normalizing," wrote S&P Global Ratings in a report on Nov. 25, predicting that default rates will rise to 8% by end-September 2021. This figure is one of the highest default predictions.

Rising debt: S&P Global Ratings adds in its report that: "Even with an effective vaccine now in sight, corporates' debt problem will not disappear." Indeed, companies have rushed this year to secure liquidity in the face of falling revenue, either drawing on revolving credit lines, raising more debt in the high-yield bond market, tapping existing loan documentation’s debt baskets to raise more loans, and/or tapping government-backed loan schemes. Moody’s notes that total bank and bond borrowing in 2020 increased by roughly $800 billion in EMEA, with average borrowing of EMEA companies (bank and bond debt only) reaching $4.8 billion this year, 15% higher than last year. "Many companies executed rescue financings to build liquidity and buy time to get through COVID-19-driven lockdowns. While those moves kept the default rate well below earlier estimates, they have also saddled companies with enough debt to raise questions about their continued viability. This will be a key area to watch next year and underscores the importance of credit selection," writes John Lapham, co-head of leveraged finance at PineBridge Investments.

Fundamentals: Although euro area GDP is expected to grow in 2021, some credit analysts note that the Eurozone economy is significantly scarred. "Corporate fundamentals, be it leverage or interest coverage, will be left significantly weakened with repairs to balance sheets likely to last well beyond the end of the year," says a credit research report from Citi. "The damage done to some companies … has left them fundamentally weaker, even though they have successfully maneuvered events this year so far," say analysts from Barclays. “We note that these are concentrated in cyclicals, particularly consumer cyclicals," they add. Meanwhile, Moody's says that 10% of EMEA companies exhibited liquidity weakness in 2020, double the level in 2019. The weakening was entirely attributable to speculative-grade companies, notes the agency.

Rating distribution: The proportion of CCC/CCC/C rated deals in the S&P European Leveraged Loan Index, or ELLI, has in November risen to the highest level by par amount since 2012, accounting for 8.5% of the market. Similarly, the share of CCC+ rated facilities in the Index is at the highest level since LCD began tracking this data in 2003, standing at 7.61% as of November 30. On its measure, Moody’s notes that the share of companies rated Caa1 or below increased to 14.5% in 2020, from 5.9% in 2019, while the share of B3 rated names increased to 25.1% in 2020, from 16.7% in 2019. "These companies… have the highest share of weak liquidity indicators. In that respect, these companies are most susceptible to any change in business conditions and are the most likely to default if liquidity weakens," Moody's said in a report in early December.

Timing of full immunization: While vaccines to protect against COVID-19 are waiting in the wings for final approval in many European countries, and with jabs already starting in the U.K. in December, there remains uncertainty as to the timing of a widespread immunization of each country’s entire population, as well as the ability to distribute the vaccine effectively. Hence, there are still question marks around when social and economic activity can return to normal, and some estimates say this may not be until at least the middle of next year. "The timing and adoption [of the vaccine] remains to be seen, meaning there is still much uncertainty around when consumption patterns may begin to normalize," says Martin Horne, head of global public fixed income at Barings. "Against this backdrop, while defaults may increase going into 2021, we believe they will remain much lower than peak-COVID forecasts."