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Despite aging credit cycle, near-term spike in leveraged loan defaults unlikely

Despite much hand-wringing of late over what some observers say is the perilous state of the U.S. leveraged loan market, a number of forward indicators suggest the segment might not see a spike in defaults any time soon, even if today's long-running, borrower-friendly credit cycle comes to an abrupt end.

To be sure, the $1.2 trillion market for leveraged loans—increasingly the focus of regulators and lawmakers, amid deteriorating lending terms and rapid growth in the asset class — has benefited from low default rates, especially compared to its counterpart in the leveraged finance market, high-yield bonds.

That remains the case today. At 1% currently, the U.S. leveraged loan default rate is holding near multi-year lows, and is markedly below the 2.93% historical average, according to the S&P/LSTA Index. But even from these most modest levels, several forward indicators suggest loans have the benefit of time before defaults will materially ramp up.

"Median leverage ratios and interest coverage suggest that if we have a recession today, the leveraged credit sector may have at least a 12-month runway before experiencing high default volume," Kevin Gundersen, head of Guggenheim’s corporate credit group, said in a May report.

Distressed test
There are a number of data points supporting that view.

LCD’s analysis of loans quoted at distressed levels (a rising distress ratio is typically a precursor to rising default activity) reveals that just $28 billion of loans in the S&P/LSTA Index are quoted below 80 cents on the dollar.

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To put that number in context, if all loans currently quoted in distressed territory were to default today, the default rate of the Index would climb to just 3.66%. Again, the historical average is 2.93%.

The current bid of a debt issue is not necessarily indicative of distress, given that higher recoveries are reflected in the pricing of leveraged loans, compared to bonds, backing a company on the verge of default. Nevertheless, according to LCD, the average bid price of Index loans at the time of default was 58 in 2018—versus just 48 in 2009, during the latter stages of the financial crisis.

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For a default to occur, an issuer must typically be unable to service debt or refinance or repay at maturity. Empirical data of credit statistics, though slightly weaker this quarter, show companies remain well positioned to manage the growing amounts of debt they’re incurring.

With most defaults occurring before debt maturity, interest coverage ratios are an important indicator of a company’s ability to service its debt. Thanks to loan refinancing activity and continued EBITDA growth, interest coverage has improved, with the weighted average interest coverage across S&P/LSTA Index issuers that file results publicly rising to 4.71x in the first quarter of 2019—the highest level since LCD started tracking this analysis in 2001.

(We'll note, however, that while interest coverage did increase in 2019's first quarter, overall EBITDA growth of these loan issuers dropped sharply, from 10% in 2018's fourth quarter to 3% in 1Q19.)

Also, the share of loan issuers with an interest coverage ratio below the worrisome 3x level stood at 28% in the first quarter. As the 2008 financial crisis began to unfold, more than 50% of issuers had coverage below this level.

The share of loan issuers with interest coverage at 1.5x or below—a level typically indicative of a company that is struggling to service debt and at high default risk—is just 3% now. It hasn’t been lower than that since late 2012, when LCD began tracking this statistic on a quarterly basis. By way of comparison, at the height of the financial crisis—at year-end 2008—the share of issuers with an interest coverage ratio below 1.5% was 18%.

Based on current interest coverage ratios, EBITDA would have to decline by 30% from current levels for average interest coverage to breach the worrisome 3x ratio, Guggenheim’s Gundersen says. This is a rough guideline, as credit metrics can vary by industry.

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And some aspects of the all-important debt ratio point to a muted default picture near-term. Typically, a median leverage ratio of 6x or greater has attracted scrutiny in the U.S loan market, particularly after regulators published guidelines to that effect in 2013. To that end, average leverage for the loan-issuer sample touched a post-crisis low of 4.76x in 4Q18, and ticked up a modest 15 bps in 1Q19, to 4.91x. That level remained below the average reading of 5.23x over the last five years, according to LCD.

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The share of issuers leveraged above the 6x threshold has crept higher since the financial crisis. On an annual read, at the end of 2007, 21% of issuers were leveraged above this level. However, the ranks of very highly leveraged issuers – those at 7x debt/EBITDA or greater – accounted for 15.4% of the Index in the first quarter, well below numbers seen during the January 2016 oil rout, when 21% of issuers were leveraged at this lofty level.

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Also pointing to relatively limited defaults in the near term: The amount of loans set to mature in the next few years is negligible, with just $22.6 billion coming due before year-end 2020. In 2021, just $57 billion is scheduled to be repaid, 56% less than what remained outstanding in 2017.

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In terms of risk, there is some $70 billion of U.S. leveraged loans rated B– or lower set to come due through 2022.

Of course, potentially lengthening the runway toward possible default is the flexibility afforded by covenant-lite loans to struggling issuers that would otherwise have been forced to the bargaining table by lenders.

Indeed, LCD’s analysis indicates that issuers have increased their time as "Weakest Links" before defaulting or restructuring. Weakest Links are loans that have a corporate credit rating of B- or lower and a negative outlook from S&P Global Ratings. They can be seen as potential default candidates.

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The defaulted or restructured credits at the end of 2018 spent an average of 2.5 years as a Weakest Link, versus 1.7 years at the end of 2017 and 1.4 years at the end of 2016.

Among defaulted loans over the last 12 months, 69% were covenant-lite. This compares to 55% in 2016 and to just 14.3% during the 2009 default peak, when the share of cov-lite credits in the loan market was a slim 18%.

Surveying sentiment
By more informal measures, LCD’s latest quarterly survey of portfolio-manager sentiment, published on April 1, continued to point to a low level of immediate concern regarding defaults. Portfolio managers, polled after the Fed’s surprise dovish move on rate and balance sheet policy, provided a consensus forecast for the U.S. loan default rate at 1.82% for the end of March 2020, a 30 bps reduction from the previous quarter’s 12-month forward read. As for the end of December 2020, the consensus estimate was 2.58%, down from the consensus estimate of 2.79% in the December survey, indicating slightly more bullish sentiment.

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Respondents also shortened their timeline for when loan defaults could finally move above the 3.1% historical average, with 75% predicting that this will occur in 2021, up from 42% at the previous read.

More telling, 25% of investors in the December read believed loan defaults would remain below the historical averages until at least 2022. Just three months later, no respondents expected it would take that long.

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While the runway to above-average defaults may still have some length to go, the potential severity in sheer volume has increased dramatically. Few expect such sudden, dramatic spikes this time around, given the dominance of covenant-lite, but the amplitude in terms of how long the default cycle will last, and market size, will impact the final defaulted amount and recovery rates.

The leveraged loan market has exploded since the financial crisis, doubling in size to $1.2 trillion currently. During the 2008 peak the share of loans quoted in distress hit 80%. At that time the Index had just $594 billion of leveraged loans outstanding. In today’s market an 80% distress ratio would amount to $948 billion of loans.

Among the Weakest Links, there are currently 79 in the Leveraged Loan Index, amounting to $65.8 billion. Hypothetically speaking, a default by these issuers would push the default rate to 7.5%.

Actual defaults peaked at 10.8% in November 2009, or a LTM defaulted amount of $63 billion. In today’s loan market, a 10.8% default rate would translate to $109 billion by amount. As things stand, the market does not expect such a dramatic spike, but the default cycle could last longer.

With a recession on Guggenheim’s radar beginning as early as the first half of 2020, the investment and advisory firm therefore expects defaults to ramp up in 2021. Guggenheim’s Gundersen cautions, however, that market valuations can disconnect from fundamentals, as experienced in the fourth quarter of 2018.

Further, high debt multiples seen in recent loan primary market issuance could cripple a borrower’s ability to raise additional financing in a more adverse economic scenario and impede access to immediate liquidity that could help extend the credit runway, increasing the probability of default in a recession.

This analysis was written by Rachelle Kakouris, who covers distressed debt for LCD News.

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