It’s been 10 years since the financial crisis, and since the famously abrupt end to the last credit cycle. The global loan markets have rebounded since then, of course, with the current long-running cycle marked by soaring issuance, record-low yields, intense investor demand for loan paper, looser covenants, and a stubbornly low default rate (though it is rising).
This cycle will end sometime, obviously, and the 10-year anniversary of the onset of the last crisis, along with the continued frothiness of the current market, has prompted much talk lately of how today’s leveraged loan world differs from the pre-crisis days of 2007–08.
To help address that issue, LCD and S&P Global Market Intelligence recently presented a live event—The Global Credit Markets: 10 Years after the Credit Crunch—featuring analysis from leveraged loan and high-yield bond market veterans, along with LCD analysts (you can replay that complimentary event here).
These charts, courtesy LCD’s Marina Lukatsky and Ruth Yang, are part of that presentation.
To compare the leveraged loan market’s standing recently versus before the credit crisis, let’s set the stage with some headline numbers.
- Size: First off, the market has grown tremendously. Per the S&P/LSTA Index, the size of the U.S. leveraged loan market is nearly $1 trillion—that’s up 72% from 10 years ago—and now comprises almost 1,000 issuers. While much of this expansion has been home-grown, the globalization of the markets is evident. Roughly 9% of outstanding loans now are courtesy companies domiciled in Europe, versus just 3% before the credit crisis. The surge in Yankee supply has largely stemmed from companies expanding operations—and having a greater need to match dollar cash flows—and from increased global M&A activity.
- Issuers: Predictably, the industry make-up of the loan market has shifted. Tech companies now account for the biggest slice of the Index, followed by Services and Healthcare. Pre-crisis, the loan issuer base was dominated by Utilities, Automotive, and Publishing (each accounted for a slim 2% of loan outstandings at year-end 2017).
- Spreads: Ten years ago loans carried an average nominal spread of roughly L+250; they offered L+340 at year-end 2017. However, looking at the discounted spread to maturity, which takes into account the secondary price, the two periods are only 10 bps apart, L+370 then versus L+380 at YE 2017. The average bid of the Index has grown over the last 10 years, from around 94 to 98, with roughly two-thirds of outstanding loans now priced at par or higher. Of course, by the end of 2007, market conditions had deteriorated significantly from the beginning of the year. Institutional loan issuance retreated from a then-unprecedented $143 billion in 2Q07 to just $46 billion in 3Q07, and the average bid of the Index fell from near-par levels to the 94 area (boosting the discounted spread to L+370).
- Credit quality: While the discounted spread is in the same ballpark now as it was in 2007, there are some concerning signals in the current market. First, let’s consider credit quality: About half the loan market is made up of riskier borrowers, those rated B+ or lower. In contrast, in 2007, only 32% were B+ or lower. Second, 75% of the outstanding market is now covenant-lite. Ten years ago, only 17% was cov-lite.
Given that the leveraged loan issuer base is currently populated by more lower-rated credits and cov-lite structures than it was 10 years ago, let’s look at how lenders get compensated for risk today, versus 2007.
The following graphic details spread-per-unit-of-leverage (SPL) for outstanding loans (the 2008 numbers are literally off the charts). To calculate this value, LCD divides the current discounted spread of the Index by pro forma debt/EBITDA ratio at closing of each loan. Again, the discounted spread was roughly the same at the end of 2007 as it was at the end of 2017. However, transactions syndicated 10 years ago were riskier, with debt/EBITDA averaging 5.7x, and with many of those deals pushing the boundaries of acceptable leverage levels. After the financial crisis, debt/EBITDA retreated, and has stood at around 5x over the last five years.
As a result, loan investors in 2017 were better compensated for risk, as measured by SPL, than in 2007: 76 bps per turn of leverage recently versus 65 bps per turn of leverage in 2007.
That being said, we’ll note that this 76 bps is a significant step-down from levels seen just two years earlier. While leverage has remained largely stable, discounted spreads have tightened, from around L+625 in 2015 and L+441 in 2016, on the back of intense demand for loans from CLOs and retail funds. As a result, SPL has dipped to the recent 76 bps from roughly 120 bps in 2015 and 90 bps in 2016.
Let’s take another look at risk, this time using current leverage and interest coverage ratios of outstanding loans at each year-end (based on borrowers that file publicly).
At the end of 2017, borrowers tracked by the S&P/LSTA Index had an average debt/EBITDA ratio of 5.3x. That’s up slightly from the 5x in 2008 but is below the recent high of 5.5x in 2014. Moreover, the interest coverage ratio, which measures how well a borrower can meet its interest payment obligations, had grown to 4.8x in 2017, the highest level in 10 years (and up from just 3.2x in 2007). Looking at this metric over a shorter period, back to 2014, borrowers had both higher debt multiples and lower interest coverage.
Moreover, for the new-issue market proper, the days of astronomical leverage are long gone. While there are a few deals in the 7x area (about 5% of the market), this is clearly the upper limit of leverage. In 2007, roughly a quarter of all LBOs were levered over 7x, and roughly two dozen were at 8x or higher.
Moving on to the secondary market, the following chart shows the average bid of outstanding loans at each year-end, and how this average breaks down by sector.
Ten years ago, all sectors priced within a tight band of about 10 points, between 86 and 96, with sectors such as Building & Development and Home Furnishings underperforming, while the Oil & Gas and Telecom sectors outperformed. With the crisis, prices plummeted across the board—regardless of sector fundamentals—as the loan market virtually shut down. Top-performing sectors dipped to the low-70s while underperforming sectors dropped to the mid-40s.
In the years after the crisis, however, this pricing gap narrowed. Over the last five years prices have held within a relatively tight 10-point band, with a few exceptions. In 2011–2013, the weakest sectors were Publishing and Transportation, and in 2014 Oil & Gas loans suffered as plunging oil prices put much of the energy sector in dire straits. In 2015–2016, O&G, Metals, and Retailers lagged. In fact, looking at the last three years—excluding these three weakest sectors—the average bid between the top and bottom sectors is just six points (from the mid-90s to slightly over par). In 2010, by contrast, this gap was roughly 13 points.
It is important to note, however, that this handful of troubled sectors has a relatively low concentration in the loan market. O&G loans account for 3% of the Index, with Retail at 5%. However, Healthcare, another sector on the watch list amid macro-level concerns, accounts for a relatively hefty 8%.
It’s impossible to talk about credit cycles—for the loan market, certainly—without focusing on LBOs.
Private equity firms sat atop a mountain of dry powder by the end of 2017, and were understandably eager to put that cash to work. This contributed to an increase in purchase price multiples, which rose to an all-time high by year-end, to 10.6x, from 9.7x before the crisis. That spike did not result from increased debt, however. It’s because sponsors were putting more skin in the game. Out of that 10.6x multiple in 2017, 5.7x came from debt, while 4.9x came from the sponsors’ equity contribution. To put it another way, the equity component represented 46% of the purchase price. Ten years ago the equity component was just 36% of the purchase price, or 3.5x EBITDA, while the debt multiple stood at 6.1x.
Turning to a more forward-looking view, this variation of LCD’s Maturity Wall chart shows the amount of near-term maturity, i.e., loans coming due in the next three years, at each year-end. The maturity wall is important, of course, because for a default to occur an issuer must typically be unable to service its debt or refinance or repay at maturity. In this respect, issuers within the Loan Index are operating with relatively healthy coverage cushions (as detailed earlier) to absorb any short-term shocks.
As of the end of last year, $102 billion of loans will come due between 2018 and 2020, representing just 11% of all outstanding loans. This is on par with the share seen over the last five years, meaning borrowers have done a sound job at managing the near-term maturity wall by opportunistically refinancing, repaying, or extending debt into the future.
This bodes well for low default rates. And in LCD’s quarterly U.S. Default Survey, conducted in March, portfolio managers again pushed out their forecast for when the U.S. leveraged loan default rate—2.4% at the end of March—will top its 3.1% historical average. Nearly two-thirds of the survey respondents (64%) expect this to be a 2020 event, while those expecting a breach in 2019 slid to 27%, a dramatic shift from the 93% with that expectation at the third-quarter 2017 reading.
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