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US leveraged loan pros: Defaults to increase slowly as credit cycle rolls on

Portfolio managers of U.S. leveraged loans expect defaults in the $1.2 trillion asset class to remain stubbornly below historical averages in the coming year, though overall those managers have a slightly more bearish outlook than they did three months ago.

In LCD's just-completed survey, managers were asked to forecast what the U.S. leveraged loan default rate would be at the end of 2020. The consensus has the rate climbing to 2.70% by then, from 1.34% currently.

The 2.70% figure is 12 basis points higher than when managers were asked the same question at the end of March.

Nearer-term, managers last month gave an average forecast of a 2.04% default rate for June 2020, 22 bps higher than the previous 12-month forward prediction of 1.82%.

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The survey responses were not all bearish, however. While the pace of U.S. leveraged loan defaults is expected to pick up, portfolio managers again pushed out the timeline for when they believe the rate will breach the 2.92% historical average for U.S. loan defaults. Just 17% now see this as a 2020 event, compared to 25% when the last survey was conducted. Fewer managers, 58%, now see this happening in 2021, versus 75% at the March survey.

A quarter of all respondents, meanwhile, believe it will not be until 2022 that the market sees above-average defaults.

The subject of loan defaults has been controversial of late, as the current, long-running credit cycle shows signs of wear and tear and as leveraged loans — along with collateralized loan obligations, the dominant investor in the asset class — come under increasing scrutiny. Loan market defenders say the slim default rate demonstrates the low volatility of the segment, which features secured, floating-rate debt. Detractors say that, with covenant-lite and other borrower-friendly loan structures all but a given now, troubled issuers can skirt distress, and even default, leaving lenders fewer options if and when conditions turn severe.

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The relatively benign default outlook is supported by the view that the central bank's apparent dovish shift toward a rate cut, and loosening monetary policy, will play a key role in suppressing default rates. Further, when the economic downturn does finally arrive, several forward loan market measures indicate that the asset class will likely have the benefit of a runway before the market sees any major upswing in defaults.

Indeed, LCD's analysis shows that issuers have been spending an increasing amount of time as Weakest Links before defaulting or restructuring. LCD's Loan Weakest Links are loans in LCD's universe that have a corporate credit rating of B– or lower and a negative outlook from S&P Global Ratings.

Defaulted or restructured credits at the end of 2018 spent an average of 2.5 years as a Weakest Link, versus 1.7 years at the end of 2017 and 1.4 years at the end of 2016.

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Ten years into an economic expansion, downgrade risks appears to be a greater concern than default risks.

According to analysts at Barclays, the U.S. loan market is more pressured by rating agency action than it was last year, with both Moody’s and S&P Global Ratings downgrading U.S. loans, and placing them on negative outlook, at a faster rate than in 2018. According to Barclays, S&P Global Ratings had downgraded 156 loans, and Moody’s 132 loans, outpacing the comparable year-to-date period in 2018.

That said, in the riskier, more troubled brackets, the current pace of downgrades of single-B loans to CCC credits is lagging the historical average, according to analysts at Barclays, who wrote that the 2019 rate of just 5% compares to a historical average of 13% for S&P Global Ratings.

About 15% of leveraged loans rated by S&P Global Ratings in the U.S. have a negative outlook, up from 2.5% at the start of 2018.

The prevalence of covenant-lite — currently 78.8% of the $1.2 trillion in outstanding U.S. loans — has been seen as a major driver behind the lower pace of defaults. But as a fund manager recently said, "you can’t covenant-lite your way around a maturity."

To that end, in terms of performing loans actually needing to be repaid, the amount of credits set to mature in the next few years remains negligible, with just $20.4 billion due before year-end 2020, according to LCD. For 2021, just $56 billion is now scheduled to be repaid, 57% less than what remained outstanding in 2017. In fact, not until 2023 do maturities really ramp up, to $204.57 billion.

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While the market may still have some time to go before succumbing to above-average defaults, the potential severity, in sheer volume terms, has increased dramatically. Again, the leveraged loan market has doubled in size since the last downturn, to $1.2 trillion currently.

During the 2008 peak, the share of loans quoted in distress hit 80%. At that time, the Index had just $594 billion of leveraged loans outstanding. In today's market, an 80% distress ratio would amount to roughly $948 billion of loans.

Among the Weakest Links there are currently 79 in the Leveraged Loan Index, amounting to $65.8 billion in loan volume. Hypothetically speaking, a default by these issuers would push the default rate to 7.5%.

Actual defaults peaked at 10.8% in November 2009, or a defaulted amount of $63 billion. In today’s loan market, a 10.8% default rate would translate to $109 billion by amount. As things stand, the market does not expect such a dramatic spike, but the default cycle could last longer.

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In the latest LCD survey, respondents were also asked to predict U.S. loan returns for full year 2019. The average prediction was 7.49%. For reference, returns through June 30 stood at 5.74%, according to the S&P/LSTA Loan Index.

This analysis is by LCD's Rachelle Kakouris, who covers distressed debt for LCD.