U.S. leveraged loan issuers in the first quarter confronted the leading edge of an already dire rise in broad-sector leverage measures, even as the COVID-19 pandemic chokes off access to the new-issue marketplace in the asset class.
Lockdown dynamics bludgeoned earnings over the back half of the first quarter, and a nearly 10% year-over-year slide in EBITDA prodded the average debt-to-EBITDA figure for U.S. public filers in the S&P/LSTA Leveraged Loan Index to 5.9x, up a full turn year over year, and marking the highest leverage reading for this public sample since LCD started running this analysis in 2001.
For a yardstick comparison, that same leverage measure moved up to 5.03x at the onset of the financial crisis in the fourth quarter of 2008, representing a slimmer year-over-year rise of one-third of a turn. Leverage readings topped out at 5.25x as the recession descended in the first quarter of 2009, and would not breach that level until the final quarter of 2013. The prior high for this credit cycle was 5.54x, in the third quarter of 2014.
Loan-default projections, muted at the start of the year, are arcing higher as distressed debt levels mount, and after 11 April defaults pushed past the prior record monthly high of 10 in October 2009. Indeed, the abruptness of the economic collapse left a wide swath of issuers on the precipice at the start of the second quarter, including nearly 30% of the public filers operating with what’s broadly considered to be “outer edge” operating leverage, of greater than 7x. For context, that proportion is up from 20% in the fourth quarter, and from a cycle-low of 14.4% in 2018's final quarter.
Further, that share is now at a high for records since 2001, and well above prior crisis-period levels of 22% in the fourth quarter of 2001 and 20% in 2008's fourth quarter.
The size of the sample does have its limitations. This quarter’s sample captured 199 loan issuers in the S&P/LSTA Leveraged Loan Index that filed results publicly, representing only roughly 17% of the $1.2 trillion overall loan universe. Further, the sample of public filers skew to a higher aggregate ratings profile than does the broader Index.
Still, the data describe a bright-line inflection since the onset of lockdowns, and predictably indicate relatively higher strains at the lower rungs of the ratings ladder. Notably, leverage for the sample's 40 issuers with a straight B rating mounted to 7.3x in the first quarter, from 5.9x a year earlier.
Leverage for the relatively small pool of 15 public filers rated B– swelled to 9x, up more than two full turns of leverage from the reading for the constituent sample a year ago. Even when accounting for the broad distribution of outcomes within the category (the standard deviation for this measure is 2.8x), the median level is elevated, at 8.6x (again, we'll note the small sample here).
As for the operating impact of the pandemic, the economic jolt from March's social distancing protocols left overall EBITDA for the sample down 9.5% year over year, following on from a flat reading in the fourth quarter of 2019, and slim growth rates of 2–3% over the first three quarters last year.
That roughly follows the early contours of the 2008 financial crisis, when year-over-year earnings flattened out in the third quarter (as the mounting housing crisis and Lehman Brothers collapse in September of that year cast a pall over the global economy), and tumbled 7% in the fourth quarter. Providing stark auguries for the months to come, loan issuer EBITDA over the first two quarters of 2009 plunged 18% and 15%, respectively.
Cash-flow disruptions, as lockdowns smothered economic activity, triggered a mad scramble up and down the ratings tiers to draw down available liquidity sources, most pointedly among leveraged issuers facing arid conditions in the loan marketplace. Indeed, March's zero-print outcome for the leveraged loan primary marked the first month-long shutout since December 2008, according to LCD.
The acute funding needs were already in sharp relief at the end of March, as cash-flow coverage of outstanding U.S. leveraged loans across the public filers in the S&P/LSTA Index, on average, tumbled 55 basis points year over year and 27 bps sequentially in the first quarter. The 2.8x coverage level marked the low since the fourth quarter of 2012, and compares to a cycle-high of 3.6x in the final quarter of 2018.
Rhyme and reason
The “outer-edge” measure for cash-flow coverage — the proportion of issuers with coverage of less than 1.5x — so far has expanded less dramatically than the leverage metric, but is nevertheless sending a directional signal that has rhymed with rising defaults in prior crisis periods. That share increased to 23.8% in the first quarter, from 22.7% in the fourth quarter last year, and a cycle-low of 18% in fourth quarter 2018.
As a proxy for the issuers' ability to service their debt on a running basis, interest coverage across the sample averaged 4.3x in the first quarter, down 25 bps sequentially, 66 bps year over year, and marking a six-year low. However, one notable difference now versus 2007 is the relatively higher level of interest coverage, even after the recent erosion. LCD measured interest coverage at just 3.2x in the final quarter of 2007, and 3.4x in the first quarter of 2008.
But for many sectors of the economy, the spigot for cash generation will stay dry so long as lockdowns persist, and consumer behavior adapts to post-pandemic paradigms. First-quarter results already reveal the stark divide between the haves and have-nots, with S&P Global Market Intelligence projecting year-over-year EPS declines for six of 11 broad industry sectors, in the context of an overall S&P 500 decline of roughly 11%.
Decliners in the first quarter include a roughly 49% plunge for the consumer discretionary sector, and material declines across the energy, industrials, financials, materials, and communications services sectors. Healthcare led the way for the remaining five sectors, with a moderate 6.4% gain projected.
This story was written by John Atkins. John is a Director at LCD News.