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Leveraged loan issuer earnings pull out of Q2 nosedive; overall leverage eases

Capital Markets View – February 2021


LCD Monthly: Demand for US loans puts borrowers in the driver's seat

Capital Markets View – January 2021

2021 Leveraged Loan Survey: Defaults edge higher; credit quality a concern

Leveraged loan issuer earnings pull out of Q2 nosedive; overall leverage eases

Third-quarter earnings across a large swath of U.S. leveraged loan issuers revealed that leveraged borrowers were on a knife's edge between recession and recovery in the third quarter, following brutal conditions over the first four months of the COVID-19 pandemic. At negative 1%, the year-over-year decline in EBITDA for the representative group moderated from negative 23% in the second quarter, and from negative 9% in the first quarter, according to LCD.

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The shallower decline in EBITDA over the latest three-month period came as the revenue contraction for the sample eased to negative 3%, from negative 13% for the April-June period.

The sample for the latest quarter includes 174 companies within the S&P/LSTA Leveraged Loan Index that file results publicly, or just over 15% of the Index, which tracks the $1.2 trillion asset class. For this analysis, LCD draws its performance metrics and total debt levels from S&P Capital IQ.

Reduced pressure on the earnings side of credit-metric calculations helped rein in rising leverage in 2020. The average debt-to-EBITDA leverage for the 174 companies eased to 6.16x in the third quarter, from 6.41x in the second quarter. Leverage remained above readings at 5.91x in the first quarter this year, and 5.13x in the year-ago third quarter.

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Meantime, cash flow coverage of debt service improved to 3.03x, on average, from 2.74x in the second quarter, in a reapproach to the 3.12x level in the year-ago third quarter. Interest coverage increased 30 basis points from the second quarter, to 4.44x, also not far from the 4.57x level in Q3'19.

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The sequential ebb in credit risk factors also saw the heat lowered under some of the most exposed credits, or those with "outer edge" leverage or coverage levels. The share of issuers in the sample with debt-to-EBITDA leverage of more than 7x declined to 32% in the third quarter, from 35% in the second quarter. The share of issuers with cash flow coverage of less than 1.5x declined nearly 7 percentage points over the same period, to 22%.

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Operating conditions for the loan-issuer group varied widely by industry, including ongoing sharp earnings underperformance for categories including oil and gas, food service, hospitality and casinos as well as industrial equipment.

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A wider view of U.S. corporate earnings confirm a bifurcated recovery period in the third quarter. Per data through late November, seven of the 11 sectors in the S&P 500 are expected to report year-over-year declines in aggregate earnings per share for the third quarter, according to S&P Global Market Intelligence. Among the decliners, however, three of the categories (communications services, consumer discretionary and materials) were on track for declines of less than 2% year over year, while the slide for financials was just 5%. Healthcare, information technology, consumer staples and utilities were pointed to higher EPS results, helping counterbalance the sharp declines for industrials, real estate and energy.

Notably, 10 of the 11 S&P 500 sectors were on track for overall profitability, if at generally reduced levels year on year. Only the energy sector was pointed to an aggregate loss for the third quarter, according to S&P Global Market Intelligence.

Pulling back even further, S&P Global Ratings last month reported that its list of global weakest links (issuers it rates 'B-' or lower with negative outlooks or ratings on CreditWatch with negative implications) included nearly half from just a few sectors: consumer service, leisure, transportation, capital goods, and oil and gas.

Of course, as a spike in market volatility in October indicated, the risk of new infection waves from the global pandemic, and the potential for emerging vaccines to stem that tide, call into question any directional signals in terms of overall credit quality. A recently updated set of U.S. speculative-grade corporate default projections from S&P Global Ratings covered broad ground, including a 12% default rate by September 2021 under its pessimistic scenario (resurgent virus rates keep unemployment high and consumer spending and GDP low), or nearly to the 12.1% peak rate recorded during the Great Recession.

But Ratings' baseline projection is still a 9% rate by next September, versus 6.3% in September this year, and its optimistic scenario calls for a 3.5% default rate next September. The agency noted reduced refinancing risk stemming from torrential debt-issuance volumes since the Federal Reserve Board's April 9 expansion of its liquidity facilities. And while that tailwind may be interrupted as some Fed liquidity facilities expire at year-end, Ratings said lingering market optimism may be propped up by the belief that "should the economy face continued stress from new waves of infection, the government and the Fed will once again provide support, where possible."

Ratings further noted that, based on historical patterns linked to where risk is priced on the open markets, the 9.5% distress ratio (defined as the number of distressed credits, or speculative-grade issues with option-adjusted composite spreads of more than 1,000 basis points relative to U.S. Treasurys, divided by the total number of speculative-grade issues) as of September 2020 corresponds with an even-lower 2.9% default rate by June 2021.

In LCD's most recent survey of risk sentiment among leveraged debt portfolio managers, which was conducted late September, respondents projected a peak for U.S. leveraged loan defaults at 6.6% and a view that the rate would start to fall in the second quarter next year.