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Borrower distress eases in first quarter, despite pandemic fallout

Corporate distress levels in Europe's leveraged loan and high-yield bond markets eased towards the end of the first quarter of 2021 due to an abundance of liquidity and other national support schemes, allowing even some of the weakest borrowers to tap new financing and avoid defaults or bridge-funding needs.

This liquidity — that has predominantly flooded into capital markets due to various pandemic-driven central bank and government measures — has driven up credit prices and suppressed yields to pre-pandemic levels. With debt investors under pressure to put money to work and hunt for yield, borrowers are "aggressively" taking advantage of the supply-demand imbalance, investors say, while adding that this situation is not sustainable. Indeed, many sources fear the trend is mispricing risk and masking fundamental problems that many corporate borrowers may not survive once central bank and government support, as well as capital market liquidity, dry up.

Loan default rate falls
Against this backdrop the European loan default rate (by principal amount outstanding) has continued to ease, falling to roughly 2% at the end of February, from a peak of 2.6% in October 2020. Indeed, the current level is well below previous expectations of a distress rate of 4% by the end of 2021, according to an LCD survey of investors in December 2020.

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The volume of defaults and restructurings, including loans and bonds, also eased, falling to €2.60 billion so far in 2021 (to March 19), lower than the €3.48 billion recorded in the equivalent period in 2020, before the global pandemic struck in earnest and forced major economies into 12 months of on-off lockdowns, many of which are still largely in place, and caused one of the worst recessions in history.

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As for raising new financing in the European loan and bond markets, this overall measure jumped to €65.6 billion in the year to March 19, which is well ahead of €44.9 billion in the year-ago period, as corporates took advantage of huge amounts of capital market liquidity to refinance existing debt or raise new financing, including transactions to pay dividends. In Europe, such activity has been fueled by the ECB's trillion-euro bond purchase programs that are pushing money into the private financial system to support economies during the pandemic.

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While government debt yields have risen recently, average yields on new term loans and bonds have largely tightened, and on single-B primary new issuance they are back to pre-pandemic levels, at 3.95% and 4.56%, respectively, for the two asset classes (through the three months to the end of February). “A year ago the loan market blew up and we were getting margin calls from one financing provider, but now the picture looks completely different,” recalls one investor.

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Open tap
Weaker borrowers that reside lower down the credit or issuer-ratings curve have also been able to tap the primary bond market, especially in the U.S. "The central banks' actions have increasingly allowed lower-rated and higher-risk issuers to access the capital markets, which provided them with much-needed liquidity to combat the economic downturn. In fact, 'CCC' rated issuance from U.S. issuers has risen steadily to date this year," notes S&P Global Ratings in a report published on March 22 titled "Central Banks, Credit Markets, And The Catch-22 Taper."

In the European market the share of CCC new high-yield issues is a lot smaller — with €2.5 billion raised from CCC rated names so far this year, accounting for 7.7% of total high-yield issuance, versus €2.9 billion raised in full year 2020 for 3.4% of the volume — but the numbers still show a rising trend that highlights more demand for high-yielding and riskier credits, including CCC rated subordinated debt from borrowers that have a single-B issuer rating.

Even borrowers whose debt traded at major discounts to par after being directly affected by COVID-19 were able to raise new money in the primary market, albeit with an equity check from shareholders in some cases. German beauty products retailer Douglas Holding AG, for example, is currently in the market with a €2.38 billion refinancing of its secured and unsecured capital structure at par to address looming maturities, supported by a €220 million equity contribution from owner CVC. The borrower was rated CCC ahead of the refinancing launch, and the existing unsecured bonds were trading as low as 61 as recently as January, but are now set to be refinanced at par via the new transaction. Ratings have so far emerged from Moody's and Fitch at B3/B- at the issuer level. The new deal also comes amid continued lockdown measures in Germany, where retailers have still not fully reopened.

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Other borrowers heavily impacted by the pandemic have also been able to raise new financings this year amid a hunt for yield by many investors, while also being heavily supported by private equity sponsors and government loan schemes. B&B Hotels (CCC+/Caa1) completed a €100 million loan at the start of March, along with €80 million from its shareholder, while Norwegian cruise-line operator Hurtigruten ASA (CCC+/B3) tapped a €46.5 million loan.

Risk equation
While these new-money raises are good news for borrowers caught up in COVID-19 restrictions, and some will have needed the funding urgently to help with operational liquidity needs and avoid defaults, debt investors — and even some bank arrangers — warn that the current tightening of corporate yields that has allowed weaker borrowers to raise debt is not sustainable, and does not properly reflect market risk. "Things are insane. We have been through a year where European economies shrunk 10% and we print CCCs at 4% and BBs at 2%, for 7- to 8-year money," says one banker.

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Though deals are clearly getting done at tighter pricing, a number of investors LCD News spoke with agree that risk is currently not appropriately priced due to investors' need to put cash to work and the hunt for higher yields in a low-interest-rate environment, as well as new collateralized loan obligation (CLO) funds needing to buy leveraged loan assets (the European CLO market is the predominant investor segment in leveraged loans). "I think there is lots of temporary money in the CLO and leveraged markets at the moment and it will drift away, and then hopefully we get a better demand/supply balance," notes another debt investor. Longer-term investors just need to keep some discipline and steer clear of the deals that are overdone and underpriced.

What's more, the current supply-demand imbalance is covering up the potential risk that the economy and some businesses will not recover as expected, some investors argue — especially when pandemic government support schemes (which range from loan to furlough schemes, as well as tax breaks and relaxation of insolvency filing obligations) are lifted.

"In the current market everything is possible. Almost everyone can raise financing. But the current speed at which borrowers are leveraging up their balance sheets with debt is not sustainable. Even borrowers in distress before the pandemic took advantage of state-loan schemes, but this has not solved their fundamental problems, and what will happen when they need to refinance government debt or emergency funding?" asked one bond investor, convinced that more borrowers will default once debt raised this year or last year will need refinancing.

"On most deals, the question is whether the borrower can take on additional debt to stay alive," adds a manager from a buyside firm. "In other words, can the company earn enough money in the future to bring debt levels down? The truth is, some leverage multiples are eye-watering, and you need a very optimistic outlook for the next few years to believe some businesses can deleverage."

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Projection room
Another manager adds that borrowers are raising financings based on earnings projections that leave "little room for error," meaning that only a small earnings miss could derail deleveraging targets. "At a fundamental level, the way some of these deals are structured and how financing cases are made not only look aggressive, but they also look very unrealistic," says the source.

However, there is some hope that the supply-demand imbalance will start to shift more toward debt investors in the coming weeks as the pipeline for new issuance to come over the next few weeks and after April looks very full, sources comment.

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"I think in six to nine months, when government support schemes come to an end, we will be able to differentiate better between the credit risk of individual borrowers, as some names will drift lower in secondary," concludes one manager.