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Leveraged loan issuer earnings rebound in Q4'20, further easing debt ratios

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Leveraged loan issuer earnings rebound in Q4'20, further easing debt ratios

U.S. leveraged loan issuers regained operational altitude heading into 2021, after the sector last fall pulled out of the steep nosedive for earnings through the early months of the COVID-19 pandemic, earnings data show. Fourth-quarter results for a representative sample of loan issuers revealed EBITDA growth at positive 5% for the October-December 2020 period, according to LCD.

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Encouragingly, that increase in the fourth quarter — an eight-quarter high — was against a healthy pre-pandemic comparison a year earlier. The sample for the latest quarter includes 157 companies within the S&P/LSTA Leveraged Loan Index that file results publicly, or just about 14% 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.

The 5% EBITDA growth in the 2020 final quarter followed on a narrow 1% year-over-year decline in the third quarter. The second-quarter plunge clocked in at negative 23% — the steepest year-over-year decline since LCD started tracking the metric in 2002. This is on top of a 9% drop in the first quarter of 2020, when a promising start to the year gave way to lockdown dynamics and disrupted credit flow through March.

Crucially, the earnings rebound has lowered the heat for issuers in terms of leverage. After earnings swooned through June 2020, average debt-to-EBITDA leverage across the loan-issuer sample spiked to a record-high 6.4x, up well more than a full turn from 5.2x a year earlier. That leverage reading eased for a second straight quarter in the fourth quarter of 2020, dipping to 5.9x, to match the 2020 first-quarter level, while holding half a turn above the reading for the final quarter of 2019.

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In terms of issuers' ability to service their debt on a running basis, the level of interest coverage improved to a seven-quarter high at 4.8x, from 4.4x in the third quarter of 2020, and 4.1x at the pandemic-era nadir in the second quarter. Cash flow coverage ticked up to a six-quarter high at 3.2x, from 2.7x at the crisis low in the second quarter.

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The operational bounce underway supports projections for a potential return to a default rate near the historical average in the quarters ahead, after defaults surged last summer, resulting in the highest default rate of the cycle (4.17%) for the last-12-months period through September. Indeed, the proportion of the "outer-edge" issuers perhaps most exposed to default risk — those with debt-to-EBITDA leverage of more than 7x, or cash flow coverage of less than 1.5x — ebbed substantially over the back half of 2020.

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More than 35% of LCD's loan-issuer sample had outer-edge leverage characteristics in the second quarter of 2020, but that share declined to roughly 26% by the end of that year. The share remains above the 20.3% reading for the last quarter of 2019, however.

Meanwhile, the share of issuers with outer-edge cash flow coverage declined to a seven-quarter low at 20.1% in 2020's final quarter, from 22% in the third quarter and 28.8% in the second quarter.

Federal policy initiatives have set the stage for further improvement. In a report published March 24, 2021, economists at S&P Global Ratings said the improving vaccination outlook, a faster reopening schedule and the recently passed $1.9 trillion stimulus — along with a $900 billion package approved in December — "all point to a seismic shift in the U.S. economic outlook relative to where it stood in December 2020."

Ratings boosted its forecasts of real GDP growth for 2021 and 2022 to 6.5% and 3.1%, respectively, up from 4.2% and 3.0% in a December report. It notes that the 2021 GDP forecast, which aligns with the Fed's new baseline, points to the highest reading since 1984.

The S&P Global economists noted risks attendant to the Fed's concerns regarding "disorderly" bond markets as investors brace for a possible inflation surge. But, messy flows notwithstanding, the inflection higher for interest rates carries benefits in terms of capital-markets access for issuers, as the leveraged sector's revival continues from a moribund first half of 2020.

The economists added that, even accounting for a possible virus resurgence in the months ahead, S&P Global Ratings pegs the risk for a technical recession over the next 12 months at only 10% to 15%. That risk projection is down 10 percentage points from forecasts as recently as January, moving it back in line with the 13% long-term average.