Wall Street would be hard pressed to recall a year to match the one it is about to exit. As the planet suffered through the worst pandemic in a hundred years, debt and equity markets first collapsed, then recovered, propelled by unprecedented stimulus from central banks. The question now confronting investment professionals: What's to come in the year ahead?
Drilling down into the U.S. leveraged loan segment, after severe weakening in the first and second quarters of 2020, credit stats of companies in the S&P/LSTA Leveraged Loan Index recovered somewhat in the third quarter. While that improvement may represent the first steps of an economic recovery in the year ahead, some believe it might just be a breather before further defaults and bankruptcies in 2021.
Before assessing the future, a look back offers some context. After opening 2020 with debt market spreads closing in on record tights and equity indices rallying to record heights, the pandemic triggered an unprecedented downdraft. The high yield market’s ICE BofA option adjusted spread, or OAS, beginning in mid-February rocketed from 356 basis points to over 1,000 basis points in roughly five weeks — and the rise from 500 to 1,000 took only 21 days, a record. By comparison, the same 500 points of widening took nearly eleven months during the 2008 financial crisis and Great Recession, and over 18 months in the 2000–2002 market swoon.
While the 2009 recovery was relatively quick compared to past recessions — the ICE BofA High Yield Index needed 237 days to rise from the trough to new highs — this year was faster, needing only 204 days. Howard Marks, co-chairman of Oaktree and a prolific chronicler of the distressed investment scene, highlighted the cause in a memo to investors that he published in October, entitled Coming Into Focus. “In the Global Financial Crisis it took authorities months to figure out what to do and do it. But this year, they dusted off the 2008 playbook and implemented it in a couple of weeks.”
This spring, the U.S. Federal Reserve flooded the economy with cash by, among other things, reducing the Fed Funds Rate to near-zero and buying corporate bonds. The result was that money poured into the credit markets. The high yield OAS peaked on March 23 at 1,087, at less than half of the Great Recession peak of nearly 2,200, and short of the 2002 peak of 1,120.
As the high yield OAS fell, companies stampeded into the market with new deals, maintaining such a blistering pace that in the first week of October high yield issuance for 2020 passed $345 billion, toppling the previous annual issuance record set in 2012 (it has since eclipsed $400 billion). Some distressed investors rode the early days of the stampede, spending dry powder on beaten-down high grade and high yield securities. An example is Boeing Co.'s $25 billion offering on April 30, the sixth-largest bond issue of all time, whose order book was salted with funds accustomed to playing in much riskier credits.
The market’s recovery can be seen in the high yield and leveraged loan distress ratios. At the end of the first quarter almost 35% of the high yield market by issuer count was trading at a spread above 1,000 basis points, the traditional level at which a bond is considered distressed. Similarly for leveraged loans, at March 31 nearly one-third of that market was priced under 80 (that market’s distressed borderline). Yet by the end of November, only 7% of the high yield bond market and less than 6% of the leveraged loan market were priced at those distressed levels.
Though faster, the 2020 market decline was also shallower than in the Great Financial Crisis, observable in the relationship between the S&P/LSTA Leveraged Loan Index distress ratio and the leveraged loan default rate. In 2008 the distress ratio (by dollar amount) peaked at 81% in November 2008, and the default rate reached its peak a full year later, in November 2009, at 10.8%. In 2020 the distress ratio peaked in March at 24% while the default rate peaked — so far — just six months later, at 4.2%.
The data points that traditionally measure the health of the high yield and leveraged loan markets are default rates. Past default rates express how good or bad things were, while next year’s projected rates reveal expectations of how good or bad things may be.
Barclays, in a report by Bradley Rogoff, Scott Schachter and Jeff Darfus, anticipates the issuer-weighted high yield bond default rate in 2021 will be 5%-6%, and the leveraged loan default rate to be 1 point inside that, at a range of 4%-5%. They derive their numbers from a combination of Barclays’ economics team’s expectation of U.S. GDP, which they estimate will grow at an average rate of 4.5% in 2021 (along with global growth of 4.8%), with an “optimism that an end to the pandemic may be within sight.”
Morgan Stanley takes a more aggressive view of the economy, and carries that opinion into the loan market. Writing in an outlook piece by firm credit strategists, Morgan Stanley expects 2021 U.S. GDP to grow at an average rate of 5.9% (and 6.4% globally), and the high yield bond default rate to peak around 10%, and finish the year at 6% — with a bear case of 8% and bull case of 3%. The firm sees the leveraged loan default rate finishing up 2021 at 3%-3.5%.
Bank of America Merrill Lynch sees an issuer-count high yield bond default rate of 5% in 2021, pointing out that “our model has shown improving estimates in each of the past seven months, after peaking at 9% in early March,” implying room for further improvement of their estimate when 2021 gets going. BAML sees leveraged loan default rates declining to 3.5% by December 2021, caveated with, “near term we expect it to touch 5.5%.”
Leveraged loan market participants seem to lean slightly more bearish for 2021. This year LCD 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 continue rebounding from the pandemic. Among respondents to the early-December survey, 70% see defaults peaking at less than 6%. Asked where the loan default rate would likely close 2021, respondents project, on average, a default rate of 4.8%.
S&P Global Ratings expects the high yield bond default rate to increase to 9% by September 2021, with a bear case reaching 12% by then. Like Barclays and Morgan Stanley, Ratings’ default rate expectation is driven by its view of the U.S. economic recovery, which it believes will resume its upward trend in 2021. The rating agency’s bull case has the default rate eventually contracting to 3.5%. It tempers its optimism by noting that “the proportion of speculative-grade issuers [rated] ‘CCC’/’C’ remains historically high, supporting a higher default rate in the next 12 months.”
Is the trend a friend?
Before the pandemic, many market watchers in early 2020 were already considering a lending segment they felt was at risk. “We remain especially concerned about the deterioration in the leveraged loan market,” said a Goldman Sachs report at the time.
Seeing things the same way, distressed debt expert Professor Edward Altman, of the NYU Stern School of Business, said in a recent interview with McKinsey & Co., “I was worried about a potential debt bubble before the pandemic,” adding, “I saw a lot of vulnerability. Not only for companies going bankrupt but also for the triple Bs, which were so popular, to be downgraded as fallen angels into the high yield and junk categories.”
There were facts behind the worry about early 2020. For instance, as reported in LCD's quarterly earnings analysis of publicly filing issuers in the S&P/LSTA Loan Index, EBITDA fell 9.5% in the first quarter of 2020 and dropped another 22.7% in the second quarter, as the pandemic’s impact reverberated across the global economy. Dragging down EBITDA in the spring quarter was a 79.9% decline in the earnings of energy companies, though EBITDA of non-Energy companies fell as well, by 19.5%.
Energy earnings continued to plummet in the third quarter, by 94.9% this time. (We'll note here that the energy segment comprises a relatively small 2.6% share of the U.S. leveraged loan market.) But in a turnaround, non-energy companies showed a 0.9% uptick in EBITDA, suggesting, along with economic statistics emerging at the time, that as a group they may have turned the corner.
A direct result of the EBITDA improvement: Credit statistics have moved in a favorable direction. For instance, average leverage at publicly filing companies in the S&P/LSTA Index peaked in 2020’s second quarter, in the teeth of the pandemic, at 6.4x debt to EBITDA. Improving from there, after 2020’s third quarter, the number is now 6.2x.
Similarly, interest coverage showed movement mirroring the improvement in leverage. In the second quarter interest coverage troughed at 4.1x. In the third quarter it ticked up to 4.4x.
Publicly filing companies in the index on the “outer edge,” of credit metrics also illustrate a possible turn. These are companies with less room for error – leverage topping 7x and cash flow coverage under 1.5x. In this year’s second quarter more than 35% of index companies carried more than 7x leverage, while nearly 29% notched cash flow coverage inside of 1.5x. Yet, as observed with the other credit metrics, there was improvement in the third quarter. Companies levered over 7x declined to 32% while companies with cash flow coverage under 1.5x dropped to 22%.
Another metric used by high yield and leveraged loan market participants is the maturity wall. In 2020, leveraged loan issuers took advantage of the tidal wave of liquidity to push out their maturities, and by extension, push the wall a bit further away.
At year-end 2019 nearly 50% of the $1.2 trillion in leveraged loans in the index were due to mature by the end of 2024. As of Nov. 27, that figure had fallen to 34% of all loans. The $166 billion difference represents 14% of the index. The maturity wall facing investors one year earlier, by the end of 2023, similarly condensed. At Dec. 31, 2019, $265 billion in loans were set to mature within three years. As of Nov. 27, $127 billion of those maturities — roughly 11% of the index — were pushed out to later years.
Looking ahead: Timing is everything
Steve Levitan, managing member and portfolio manager at Scott’s Cove Management, observed that as the market recovered through the summer of 2020, it bifurcated into large companies with ready access to credit markets, and small companies without that ease of access. He described some of the small distressed situations he follows as “burning the furniture to heat the house, and they’re running out of furniture.”
Along with the trouble faced by small enterprises, Levitan believes that even if, helped by the rollout of a vaccine, the global economy returns to a more normal footing by the middle of 2021, “you still have six months of trouble ahead.” He believes that in spite of the liquidity the markets have provided, customer behavior isn’t going to change overnight, citing theaters, hospitality and travel industries as three sectors that might not get the sudden snap-back investors may be hoping for.
Levitan thinks a low-400s high yield OAS — roughly the high yield market spread today — is not where it should be at this point of an earnings recession, but concedes that the Fed’s unlimited balance sheet can take credit for keeping the market trading at this level.
BAML is more sanguine about the high yield spread, at least when compared with the start of 2020. In its 2021 outlook piece, penned in November, it wrote, “All else being equal, we view the value proposition of the HY bond market as being better at current levels than we did at this point last year. Simply put, the market at close to 450 bps offers a better cushion against things going wrong than it did in the low-300s.”
Concurring with Levitan’s view of what’s to come by the summer of 2021 is restructuring expert and Houlihan Lokey managing director Saul Burian, who thinks that further Fed stimulus, fiscal policies, cheap credit and the vaccine could keep markets healthy through the first quarter. But after that, “I’m expecting another avalanche in the second quarter,” Burian said, referring to defaults, restructurings and bankruptcies.
Burian says some deals are being cut today on expectations that company performance will have returned to at least 2019 levels by the middle of 2021. That, he believes, might not be realistic. When performance misses that mark, the resultant shortfall will necessitate new balance sheet adjustments, and more work for restructuring bankers.
Barclays’ John Cortese, managing director and co-head of U.S. credit trading, adds another element: interest rates. Referring to their movement in 2021, he says, “A slow leak wider won’t hurt, but big sudden spikes could create a flight to cash.”
In fact, as Oaktree’s Marks said in Coming Into Focus, “The kneejerk reaction to trillions of dollars of deficit spending on the part of the Treasury and further trillions of dollars of bond buying by the Fed is to worry about inflation.” Marks adds that as a percentage of GDP, the U.S. national debt now approaches a high last seen after the Second World War.
Morgan Stanley sees a similar view on the horizon. “A key aspect of our macro outlook is the expectation that 2021 will see a stronger reflation impulse in the U.S.,” adding that “U.S. inflation is set to rise above 2%Y on a sustained basis from 2022 onwards.”
For the shorter term, it is worth remembering that the Federal Reserve has publicly said it expects to keep the Fed Funds rate near zero through 2022. That timing fits neatly into Morgan Stanley’s inflation outlook.
BAML reminds investors that, “Strong structural headwinds have kept inflation low and trending further lower for well over two decades now.” Noting that the Fed has shifted its target to average inflation, implying it “will tolerate an overshoot over [the] 2% earlier target for some time,” the BAML report says that “we don’t have particular reasons to suggest why most structural factors that worked towards lower inflation in the past would fail to work in the future,” a stance BAML sees the market confirming, saying the market is pricing in very little chance” of inflation materializing.
Of note, the BAML report concludes the discussion with, “This fact keeps us focused on exactly such a scenario.”
A look at the sectors containing loans priced under 80 at Nov. 30 could provide a hint as to which sectors could be ripe for defaults and bankruptcies in 2021. Leading the data is the Leisure sector, whose loans make up 4.2% of the $1.2 trillion in outstanding U.S. loan debt. Some 12.3% of loans in that sector are priced under 80. Oil and gas, a sector seemingly on everyone’s radar as either one to avoid or one ripe with opportunity, makes up only 2.6% of the index, though it is second when ranked by the percentage of its loans trading under 80, at 10.3%.
Houlihan’s Burian notes a few particular sectors that he expects to behave favorably in 2021, including tele-medicine, video services, home improvement — including furnishings, outdoor furniture, and gardening — and athleisure. Golf, he noted “is exploding,” as is last-mile delivery.
On the flip side, Burian thinks sectors that are likely to remain challenged through 2021 include automotive suppliers, middle-class leisure and hospitality, airlines, commercial & retail real estate, and entertainment.
Barclays' co-head trader Cortese echoes the opinion that retailers are in for further rough sledding in 2021. But to him, in 2021, even more important than sector selection will be asset selection. “Picking your individual credits will be super important,” Cortese says.
BAML research opines on recent trading behavior of some sectors, using that to glean how they might behave in 2021. It looks at price deviations from the broad high yield market trend, saying, “The most extreme positive price deviations from a trend usually lead to subsequent underperformance as the price momentum ‘cools down’ to return back to a less extreme level.”
BAML identifies real estate, chemicals, tech, and financials as sectors exhibiting that positive trend deviation. On the reverse slope, BAML says, “Sectors with smaller price deviations could potentially catch a better bid as investors play catch up there.” It cites telecoms, cable, utilities, and health as sectors to watch.
Scott Cove’s Levitan notes that technology and homebuilders have performed extremely well through the pandemic, and in what he characterizes as the Fed’s “lower forever” accommodative stance, are likely to continue performing well.
Regarding distressed opportunities generically, Levitan, who’s been investing in distress for over 30 years, concedes “Distress is going to be tough. There’s an awful lot of cash waiting for opportunities.”
James Bentley, a bankruptcy lawyer at Winston & Straw in New York City, notes that video conferencing capabilities like Zoom “have changed business travel forever.” He is not expecting people to return to a five day in-the-office workweek, That, he says, will impact real estate, hospitality and travel companies.
Referring to the energy sector, Bentley noted, “We didn’t see the explosion in the number of Chapter 11 cases we initially expected in 2020, although the amount of debt associated with those companies that did file for bankruptcy has been significant.”
Seconding Bentley is Brock Hudson, a managing director and banker at Carl Marks Advisors. Though busy, he expected to be even busier, saying he probably hasn’t been “because lenders understand the difficult challenges the industry is facing and are not looking to push companies that can survive and recover over a cliff.”