In the latest example of how thoroughly the coronavirus pandemic and subsequent economic fallout has upended the usually less-volatile U.S. leveraged loan asset class, the ranks of 'Weakest Links' in the market swelled by a whopping 57% during the first quarter, according to LCD.
Weakest Links are loan issuers with a relatively risky corporate credit rating — B-minus or lower — that have also been put on negative outlook by S&P Global Ratings. Historically, an increase in the number and share of loan Weakest Links indicates a heightened risk of default, an occurrence the $1.2 trillion asset class has largely sidestepped during the long-running, just-ended credit cycle.
As of March 31, the number of loan Weakest Links spiked to 227, from 145 in December and from 125 in September. That is an 82% increase in six months.
The first-quarter surge brings the Weakest Links share of the U.S. leveraged loan market to 17.3%, up from 10.9% at the end of 2019. This is, hands down, the largest count and share of loan Weakest Links that LCD has tracked since the study’s base date of year-end 2013.
(Note: The loan Weakest Links composite can change historically, as LCD's coverage expands the universe of loans it tracks for the purpose of this analysis. Also, the data set from which the Weakest Links analysis is draw is slightly larger than the $1.2 trillion in current loan outstandings, per the S&P/LSTA Loan Index).
Related to debt issuers encountering rocky terrain last month: With the coronavirus shuttering businesses and wreaking havoc on the U.S. economy, companies are increasingly drawing on bank lines to lock in liquidity. Of the 227 Weakest Links tracked by LCD, 34 also are components of LCD's revolver drawdown tracker—a list and industry breakdown of companies that have tapped existing revolving credits since March. 5.
Under normal economic times, these lines of credit could go largely untapped.
Defaults, downgrades, distress
The number of issuers in default and undergoing restructurings in the Weakest Links analysis declined to 16 as of March 31, from 27 as of Dec. 31 and 21 in 2018. Ten of these borrowers had previously been on the loan Weakest Links list, such as Pier 1 Imports and American Commercial Lines. However, this dip in the ranks of troubled credits is temporary. The cutoff date for the Weakest Links analysis was March 31. The U.S. leveraged loan market recorded 11 defaults in the first 14 business days in April, making it the busiest month for defaults (by count) since the inception of the S&P/LSTA Leveraged Loan Index.
The number of Weakest Links rose in the first quarter due to the seemingly relentless wave of credit downgrades, along with a worsening outlook. Of the 227 Weakest Links issuers, 97 are new to the cohort, with 43 joining as a result of a one-notch cut to B– (with a negative outlook). Another 42 borrowers already had a B– rating, but had a change in outlook, to negative, between January and March.
As the pace of downgrades intensified in the wake of the COVID-19 pandemic, the share of issuers in the S&P/LSTA Index rated B– or lower rose to 28.2% in March, the highest ever, and a 2.4% increase from February. That is the largest monthly increase since November 2008, when this metric jumped 3.5%, to 24%.
The effect of the COVID-19 related downgrades and worsening outlook is apparent when looking at new Weakest Links by sector. The highest number of first-quarter additions came from Computers & Electronics (LCD’s proxy for the technology sector) and Healthcare, at roughly a dozen each. However, these sectors also hold a dominant position in the loan market overall, accounting for 15% and 9.5% of the $1.2 trillion institutional market, respectively, based on the S&P/LSTA Index. Their leading position is in line with their overall presence in the loan market.
In contrast, Entertainment & Leisure—a sector heavily impacted by social distancing measures—saw a large spike in Weakest Links. Ten borrowers joined the list over the past three months, bringing the total to 13 (three were in the cohort last year). On the other end of the spectrum, Telecom and Food & Beverage—two sectors more insulated from the impacts of the pandemic—each saw just one new borrower join the ranks of Weakest Links last quarter.
Looking at the data another way, the above chart shows each sector's share of the total Weakest Links as of March 31, versus the end of 2019, based on issuer count. Entertainment/Leisure now accounts for a roughly 6% share, versus just 2% in December. The Computers/Electronics share rose to 12%, from 10%, while Healthcare rose to 13%, from 12%.
Retail, a sector which has dominated the corporate default landscape in recent years, saw a reduction to 7% from 10%, as the majority of other sectors gained share. While Retail faces strong headwinds from social distancing measures and the general state of the economy, most of these borrowers have been on investors' distress radar for some time now. Out of the 17 borrowers from the sector on the current list, only five joined the cohort this year.
Looking more broadly at credit issues in the asset class, as of April 15 the U.S. leveraged loan default rate, by issuer count, rose to 2.62%, its highest level since December 2010, moving closer to the 2.9% historical average. Again, an increase in the loan Weakest Links ranks implies a heightened risk of default down the line. Indeed, 47% of loans from the year-end 2016 cohort have since defaulted or restructured, while 32% of loans from the year-end 2017 cohort have defaulted or restructured, and 22% of those from the end of 2018 have done so.
Beyond default rates, another factor pointing to the health of the loan market is the ratio of downgrades to upgrades, especially those at the lower end of the credit quality spectrum. The downgrade/upgrade ratio hit an unprecedented 11.4:1 at the end of March. The next-closest figure, which is compiled on a rolling three-month basis, is from January 2009, as the loan market was still in the throes of the Great Financial Crisis, when the ratio was 8.45:1.
This analysis was written by Marina Lukatsky, who oversees LCD Research.
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