In recent months, spreads over Libor on leveraged loans to B-minus rated issuers have grown increasingly aligned with those in the B-flat cohort, as yield-starved investors continue to pile into the U.S. leveraged loan asset class, chipping away at the risk premium investors traditionally have seen on lesser-rated credits.
Indeed, in the second quarter, the gap between the B-flat and B-minus equivalent loan buckets narrowed to just 18 basis points, with B-flat loans pricing at an average of L+420, and the B-minus loans at L+438. Although the gap widened to 27 bps in the three months through Aug. 3, it compares to an average interval of 54 bps in the three years leading up to the coronavirus pandemic, and to 92 bps in the early, most-distressed stages of the outbreak.
While this narrowing indicates a declining risk premium on B-minus loans for institutional loan investors — including CLO managers — it underscores greater manager confidence in the riskier credits that lie just one notch above triple-C ratings. The relative comfort managers have with B-minus loans is also helping fuel the record pace of primary CLO issuance this year ($92.4 billion through Aug. 2) and refinancing/reset activity ($152.8 billion).
In some ways, CLO managers have little choice but to consider B-minus loan collateral. B-minus loan issuance — driven heavily by LBO and refinancing activity — has already set a record in 2021, with five months left to go. LCD tracked $156 billion of issuance from borrowers rated B- by at least one rating agency in the year to Aug. 3, more than any full-year tally on record. In addition, B-minus borrowers now account for 24.2% of the $1.26 trillion loan market, based on the S&P/LSTA Leveraged Loan Index, just below the all-time high of 24.8% on June 30.
But CLO managers are also expressing more confidence in the B-minus rated corporate borrowers themselves — in contrast to the rising concerns over troubled corporate borrowers in the midst of economic stress from the coronavirus pandemic.
"B-minus companies that are [now] coming to market are new LBOs, [and] they have these massive equity cushions underneath them," said Lauren Basmadjian, co-head of liquid credit and head of U.S. loans & structured credit at The Carlyle Group. "It is a B3, it has eight turns of leverage, but the business has just been bought for 20 [turns]."
"These companies that are coming tight, they're really good companies," added Michael Marzouk, a managing director and portfolio manager for corporate bank loan and CLO strategy for Pacific Asset Management. "Companies have the capacity to add leverage. It's cheap to borrow, so why not?"
Resource Label Group and McGraw-Hill Education Inc. are among a growing crop of B-minus issuers this year tapping the loan market to take advantage of the tight spreads for refinancing and/or the large private equity appetite for LBOs. Each holds stable or positive business outlooks from S&P Global Ratings or Moody's, and they have priced deals at similar rates (a range of L+425 to L+475) to those of B-flat issuers, such as Jo-Ann Stores, according to LCD.
Market trends are also forcing managers into the B-minus loan space. Declining yields across the board continue to fuel investor demand for lower-rated and higher-yielding paper. In fact, the average discounted spread on B-minus loans as of June 30, at L+458, nearly matches the post-Global Financial Crisis low.
Historically, CLO managers have been sensitive to the allotment of B-minus paper amid their holdings. A one-notch downgrade across a number of loans could result in a breach of limits on triple-C holdings (typically 7.5% of a CLO vehicle’s notional value).
And until a ratings methodology change by Moody’s in December, a negative outlook on a B-minus issuer would result in a B-minus loan being treated as a triple-C asset, for purposes of Weighted Average Rating Factor (WARF) tests.
Moody's now treats a B-minus asset at its current rating, regardless of outlook status. That, plus factoring in stronger financials and declining corporate-default-rate expectations, are giving managers more faith in the potential performance of B-minus assets.
"Last year, a lot of collateral managers, as well as tranche investors, were very focused on what the B3-/B- concentrations were, because they were very close to becoming triple-C loans," said Dan Ko, portfolio manager at Eagle Point Credit Management. "As the market has rebounded from COVID, the triple-C buckets have come down, the parameters have obviously gotten more comfortable" for both collateral managers and investors.
There are other reasons for optimism on the credit front. Leveraged loan default expectations are at near-record lows. The U.S. leveraged loan default rate has fallen at a rapid pace in 2021, to just 0.58% at the end of July, compared to the cycle peak of 4.17% in September 2020.
Upgrades of leveraged loans are also now outpacing downgrades at the fastest rate since June 2011, according to LCD. The ratio of upgrades to downgrades of loan facilities in the S&P/LSTA Leveraged Loan Index in the three months through the end of July climbed to 2.3x, the sixth consecutive month that upgrades exceeded downgrades.
Larger transactions are more liquid, and are carrying earnings momentum, too. According to LCD, average pro forma EBITDA for leveraged borrowers this year is $246.3 million, compared to $168.2 million in 2019. This change is in part driven by middle-market borrowers shifting from the syndicated market to direct lending — leaving the B-minus market with large and more-liquid borrowers.
One of the main drivers of greater B-minus issuance is the high level of LBO-related loan volume, which totaled $42.6 billion in the second quarter, across all ratings buckets. That level is the highest since the global financial crisis. Some 64% of last quarter’s buyout volume came from borrowers rated B-minus on at least one side, up from 49% in the first quarter but on par with the second half of 2020.
B-minus loans are being issued this year at debt levels (6.1x) that surpass post-financial crisis levels. While that rate is only slightly higher compared to 2019 and 2020, B-minus loans are also being issued with post-crisis record interest coverage levels (3.2x), according to LCD.
Within the LBO universe, B-minus deals are also being issued at much higher purchase multiples, of 12.8x vs. 10.2x for B-flat or B+ loans, according to LCD. The equity contribution was also higher among B-minus issuers — at 47% versus 40% (these numbers are based on borrowers with more than $50 million of EBITDA).
Those rising enterprise values provide added protection for lenders and CLO managers, noted one manager. If, for example, a private equity firm is paying 15-20 times earnings for a business, the manager said, then the issuer is less likely to default, at the risk of turning in the keys to lenders and investors.
"They're not going to give up the company for failing to make a 4.5% payment," said one CLO portfolio manager. "I think everybody has a pretty clear alignment of interest."