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European leveraged loan downgrades slow, but risks remain elevated

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European leveraged loan downgrades slow, but risks remain elevated

The number of borrowers in Europe's leveraged loan market downgraded by S&P Global Ratings has returned to levels last seen before the COVID-19 crisis reached the continent a year ago. Indeed, the recent slowing in the pace of downgrades has led to optimism that defaults will remain below expectations this year, market participants say, despite the level of riskier, CCC-rated borrowers in the market staying high.

There were 17 downgrades in the S&P European Leveraged Loan Index in the three months to January this year, which is the lowest such reading since December 2019, highlighting the gradual decline since downgrades peaked at 78 in the three months to June 2020.

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Against this backdrop, the number of borrowers in the index being upgraded has increased to the highest level seen in five years, as many companies emerged from restructuring processes completed in 2020. The upgrade tally peaked at 10 in the three months ended November 2020, according to LCD, before easing slightly to nine in December and eight in January. These readings represent the highest number of upgrades tracked on this measure since April 2016.

Meanwhile, the ratio of downgrades to upgrades has fallen to 2.13x, which is the lowest since December (meaning for every upgrade, there were 2.13 downgrades). In April 2020, this ratio peaked at 56x before gradually declining.

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Looking at S&P Global Ratings' measure, the agency recorded a total of 36 upgrades (this includes both high-yield bond and leveraged loan borrowers, unlike in the loan-only ELLI) in the fourth quarter of 2020, including 12 companies that were upgraded following an emergence from restructuring or default. Nine borrowers were upgraded from CCC, another nine from single-B categories, and another six from the BB segment. Among the 43 downgrades tracked by S&P Global Ratings, the majority (25) came within the B category.

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Migration picture
Market players note that negative ratings migration is a precursor to defaults, and with this picture having improved to show more positive ratings migration, some have revised their expectations accordingly. "In our view, the 12-month trailing global default rate in speculative grade bonds was likely to peak in the US at close to 7% and in Europe it would be maxing out at just under 5%. By year-end, however, we thought the default rate could be back below 5% in the US and below 3% in Europe," wrote Mark Holman, CEO of TwentyFour Asset Management, in a blog post. "Not only would these be incredibly low figures given the economic stress, but also the pace of change implied here would be like nothing we have seen in previous economic cycles," he added.

"I wouldn't even be surprised if the default rate slips below 3% in Europe," notes a European portfolio manager, adding that the amount of liquidity borrowers have been able to raise in the European primary leveraged loan or high-yield bond market has taken many by surprise and gives another reason for broad optimism as corporates have access to liquidity.

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Looking at the monthly lagging 12-month default rate in the ELLI by principal amount outstanding, this measure peaked at 2.61% in October, and had fallen to 2.13% by January this year. A survey carried out by LCD in December showed that investors expected this rate to rise to 4% in 2021.

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Risk factors
Despite slowing downgrades, risk is running at elevated levels in the European leveraged loan market. The percentage of borrowers in the ELLI in the CCC/CC/C rated categories remains at a roughly six-year high, at 8.5% for January, December and November. Such readings represent the highest level of CCC/CC/C rated borrowers in the ELLI since May 2012.

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Meanwhile, the percentage of B- rated names has also increased — to more 22%, which is the highest share on record, according to LCD.

It is worth noting that not all B- or CCC rated borrowers are on the brink of a debt restructuring or default or are in urgent need of rescue financing. What's more, many borrowers in these categories are currently able to tap new financing lines — even for opportunistic refinancing — in the primary market by drawing on an investor base that is in risk-on mode and awash with cash. Biogroup LCD for example, rated B- by S&P, and its CCC rated bond entity (Laboratoire Eimer) was in January able to place a €2.5 billion loan and bond refinancing. The CCC rated bond issuing entities of Verisure AS also placed an opportunistic dividend recap in January, in this case as part of a €4.4 billion debt package.

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CLO limits
Exposure to CCC assets is of particular importance for managers in the CLO market, which is the predominant investor segment in European leveraged loans, as these players have limits on the percentage of CCC-rated assets they are allowed to hold — typically no more than 7.5%. If the level of CCC exposure is higher than this, it could affect the overcollateralization, or OC, test of a CLO, which in turn could result in fines or interest payment cutoffs for shareholders.

According to research published on Feb. 19 by Morgan Stanley, which looked at the latest CLO trustee reports collected by Intex, junior OC levels have deteriorated over the past few months. According to Intex data, five CLOs have junior OC test cushions below 50 basis points, and an additional four CLOs are failing their interest diversion tests.

Morgan Stanley adds that in 45% of the CLO universe, the 7.5% CCC/Caa limit is being breached at at least one of the rating agencies. According to the latest trustee reports, the median CCC/Caa bucket for the EU CLO universe is around 6.3% now, compared to a median of 2.5% reported before the COVID-19 pandemic, the research said. Using the worst reported bucket for each deal across the three agencies (Moody's, Fitch and S&P), Morgan Stanley calculates a median worst bucket of 7.4% across the European CLO universe. The bank expects the percentage of CLOs with at least one CCC bucket above 7.5% to rise to 74%, while the median CCC/Caa based on the worst bucket for each CLO should rise to 9%.