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Europe's leveraged loan market: COVID-19 crisis echoes '08 in depth, not scope

Leveraged finance markets collapsed in the wake of COVID-19 spreading into Europe and the U.S., in a way not seen since the global financial crisis, or GFC, more than a decade ago. But while the depth of this year’s crash echoes the falls recorded in 2008 — with primary leveraged loan activity shutting down in each case — further comparisons are harder to draw, and LCD data reveals key differences in the way markets have behaved.

This year’s plunge in leveraged indices was certainly severe, just as it was in the GFC — though it did not exactly reach the depths plumbed following the collapse of Lehman Brothers. Indeed, the S&P European Leveraged Loan Index, or ELLI, reached a nadir of 59.05 on Jan. 1, 2009, which compares to a low this year of 78.92 on March 24.

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The fall this year was undoubtedly dramatic, however. The ELLI opened 2020 at 98.28, and reached a year-to-date high towards the end of January at 98.66. It then bobbed around this level until the end of February, when it fell from 97.60 into the high-70s in a little over three weeks. During the GFC it took more than a year from when the ELLI first dipped below par (and then 99) in July 2007, for it to reach the 70s, in October 2008.

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Rational approach
This year’s rapid fall was also followed by a sharp snap back, which took the ELLI back through 85 from its low in roughly a fortnight. Movements in individual credits were even more pronounced, with names such as Verisure, TDC, and Techem moving up from the 80s to the mid-90s in a matter of days.

So, what was different this time around?

"In the last financial crisis, we saw a lot of dumping of positions," said a banker. "But this time, there has been a more rational approach to what is happening."

Previously, for example, forced selling from levered buyers using total return swap (TRS) lines created a downward spiral, which particularly damaged the post-GFC market. The sell-off this March undoubtedly brought outflows, say sources, who point to a slew of 'Buyers Wanted in Competition' portfolios emerging in the latter part of the month (for a March total of €1.3 billion on this measure), but this activity was generally due to separately managed account and other multi-strategy funds rotating out of the asset class, rather than a wholesale dumping of positions.

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"The market was weighted towards the demand side, but we’ve not seen huge redemptions out of loans," said one investor. The rapid markdown in secondary loan markets meant a handful of funds with ready cash saw their opportunity and stepped in to pick up double-B-style names in defensive industries such as Telecom, before moving to look at more credit-intensive single-B names. Buyers from collateralized loan obligation vehicles, or CLOs — a cornerstone of demand for leveraged loans — were generally less active during both the sell-off and the rally, sources add.

Sector spotlight
Just as in 2008, secondary market price losses were seen across the board — though sectors more insulated from the effects of the coronavirus outbreak, such as Telecom and Cable, Food, and Publishing, fared considerably better this time around. Meanwhile, those industries in the crosshairs of the shutdown amid the current crisis, such as Retail and Construction, performed much worse.

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These differing outcomes reflect the diverse nature of the two crises.

"This is a completely different scenario," said a senior banker of the current crisis. "2008 was a shutdown in financial markets, while today is a fundamental shutdown in economic activity." Indeed, in contrast to the GFC, banks today remain solvent, and when it comes to leveraged finance their balance sheets are far less clogged up with unsold positions.

In all, LCD counted €18.45 billion of deals underwritten and being readied for launch at the onset of this crisis, which compares with roughly €32 billion at the start of the GFC. Today’s tally is also more dispersed among underwriters than in 2008, meaning lenders maintain — publicly at least — that they are generally relaxed about their positions, sources say.

"It’s not the same as 2008, as most banks have two, three, or four deals on the balance sheet, and there are no 50/100% underwritings like we had back in the day," said one market source. And direct lenders that saw a potential opportunity to pick up cut-price assets say that there so far appears to be little movement from underwriters to offload positions at attractive discounts.

However the situation for many banks after the collapse of Lehman Brothers was catastrophic, with multibillion-pound deals backing buyouts such as EMI Entertainment World Inc, AllianceBoots, and Acromas Financial Services Ltd. left hanging with little or no chance of sell-down. The sheer scale of these post-GFC challenges saw many previously dominant banks either severely curtail their leverage finance businesses or close them down completely. Bank lending capabilities, too, have never really recovered to pre-crisis levels.

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Waiting for the elevator
In comparison, the largest financing left unsold this year is the roughly €8.5 billion, drawn and undrawn package backing Advent, Cinven, and RAG’s €17.2 billion buyout of the Elevator Technology business of Thyssen Krupp Stahl. The debt here includes around €2 billion of undrawn lines, and the entire financing is split with a lead underwriting group of six banks. The deal was signed just a week or so before the coronavirus-led sell off, and a sub-underwriting phase is said to have found little traction.

For the moment, few expect the syndication market for these types of deals to open anytime soon.

"There will be a flight to quality and the first launches will be for double-B style credits in sectors less affected by COVID-19," said one manager.

Just as in the years after the GFC, the high-yield bond asset class is expected to take the lead, with known issuers looking to extend tenors or source new liquidity. Overall, the European leveraged loan market may be slower to get going than its U.S. counterpart, given the availability of government lending schemes in Europe, sources add. M&A and buyout deals are also unlikely to feature significantly, as sponsors focus on their portfolios. That said, add-on transactions and opportunistic public-to-private deals are a possibility, sources say, as banks and direct lenders maintain they are open for business — albeit at significantly changed terms.

The COVID-19 crisis is far from over, too, and sources agree players have yet to see its full impact on leveraged portfolios. Bankruptcies and impairments are certain to increase, with Moody’s last week predicting the European default rate will rise to 8.5% by the end of March 2021. This certainty of further disruption means plenty of bankers and managers across the market argue the recovery in leveraged debt seen in secondary trading has moved too quickly, and it is too early to draw conclusions from this or previous crises.

"The rally is premature and we have yet to see the pressure come through in corporate earnings," concludes one manager.

This analysis was written by David Cox, who covers the European leveraged finance market for LCD.

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