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US leveraged loan default rate dips to 3.25%, approaching historical average

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US leveraged loan default rate dips to 3.25%, approaching historical average

The trailing-12-month default rate of the S&P/LSTA Leveraged Loan Index fell for a fifth consecutive month in February, to 3.25% by amount, from 4.17% in September. The September level was the highest in the current cycle of above-average defaults.

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Without a fresh wave of new bankruptcies and payment misses, the loan default rate could fall back to below the 2.9% historical average in a matter of months. April through July was a particularly active period of default activity in 2020, and $30.8 billion of defaults are scheduled to roll off the calculation over those upcoming months.

Hypothetically, calculating from February's amount outstanding in the index (excluding defaults), that would take 267 basis points off the 3.25% default rate, assuming no new defaults.

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February's $1.15 billion of defaults, from two issuers across three loan facilities, gives a 12-month trailing volume of $38.28 billion, which remains 79% ahead of the February 2020 pace.

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Kick-starting the month, Charlotte, N.C.-based department store operator Belk Inc. missed the interest payment due on its second-lien term loan and the scheduled amortization payment due on its first-lien term loan, prompting a Feb. 2 downgrade to D by S&P Global Ratings and triggering a default in the Index. The retail chain on Feb. 23 filed for Chapter 11 protection in the U.S. Bankruptcy Court for the Southern District of Texas with a prepackaged plan to eliminate $450 million in debt and exit bankruptcy in less than 24 hours after filing.

U.S.-based sock manufacturer Renfro Corp. triggered a default after it effectively converted the cash interest payments on its original $220 million ($135 million outstanding) term loan due June 2021. S&P Global Ratings, in a Feb. 19 report downgrading the term loan to D, said it views the transaction as distressed and tantamount to default, as the conversion of the term loans to all-PIK interest will slow the cash interest payments for its lenders, relative to its original promise under the agreements.

Distress, less and less

Thanks to the supportive market conditions that have allowed troubled companies to prove they have access to liquidity by funding in the leveraged finance markets, and the scores of companies securing breathing room on credit terms, the share of loans priced in technical distress — i.e., below 80% of face value — fell to 1.53% at the end of February. That is the lowest month-end reading since September 2018. The share below 70 is almost nonexistent, with just 0.43% of loans below this level. At the March 23, 2020, peak, 57% of loans were below the 80-mark and 15% below 70.

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The composition of sector distress has significantly changed from both pre- and post-pandemic levels. Oil & Gas and Retail — two mainstays of distress in the otherwise benign credit cycle — now boast sector-level distress ratios of just 6.4% and 0.9%. During the height of the pandemic lockdowns and early-2020 oil woes, these sectors had a distress ratio of 64% and 46%. Even before the pandemic, Oil & Gas in the five-years through December 2019 averaged a sector-level distress ratio of 29%, hitting peaks north of 80% during the 2016 and 2020 collapses in oil prices. Retail, from January 2016 to the end of 2019, averaged a distress ratio of 14%, before hitting 52% in March 2020 with the pandemic-related lockdowns.

Other sectors to fall into distress with the pandemic, such as Leisure, Air Transport and Hotels & Casinos, have fully rebounded.

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Meanwhile, Business Equipment & Services, despite having a sector level distress ratio of 2.6%, makes up 17% of all distressed loans owing to its higher share of the index, at 10%.

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In terms of ratings composition, the broader US leveraged loan market saw a slight uptick in the share of B- rated issuers, to 24.7%. With the three-month rolling count of upgrades (46) exceeding the count of downgrades (38) for the first time since February 2017, this trend was driven entirely by a banner pace of loan issuance from this ratings cohort.

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Meanwhile, the count and share of U.S. leveraged loan Weakest Links retreated again in the fourth quarter, after hitting the highest level in at least eight years in the second quarter, according to LCD. Despite this improvement, the number of Weakest Links remains 70% higher than it was at the end of 2019.

LCD's loan Weakest Links are loans in LCD's universe that have a corporate credit rating of B- or lower and a negative outlook from S&P Global Ratings. 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.

As of Dec. 31, the number of leveraged loan Weakest Links fell to 248 issuers, from 295 at the end of September and 329 at the end of June, which was the highest level since LCD began this analysis in 2013. The final reading for 2020 includes 21 more issuers than in March — prior to the COVID-19-related downgrade spike — and 103 issuers more than at the end of 2019. The loan Weakest Links share of the overall market fell to 19% on Dec. 31, from 22.5% on Sept. 30 and 25% on June 30, but remains above the 17% on March 31 and 11% at the end of 2019.

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The universe of loan Weakest Links shrinks when more loans exit the cohort — either due to default, a ratings upgrade, an improvement in outlook or a ratings withdrawal — than join the cohort. The biggest driver of the decline in Weakest Links in the fourth quarter was the improvement in outlook on 46 issuers. While these companies are still rated B- or triple-C, the majority now have a stable outlook.

In addition, the pace at which loan borrowers became Weakest Links slowed markedly in the fourth quarter. The count of upgrades in the S&P/LSTA Leveraged Loan Index has nearly reached parity with downgrades, in what amounts to a dramatic turnaround from earlier in 2020. In fact, LCD added just 15 issuers to the ranks of Weakest Links in 2020's fourth quarter. To put this number into perspective, a whopping 137 borrowers were added to the Weakest Links tally in the second quarter.

What's more, the share of defaults and restructurings in LCD's Weakest Links analysis retreated to 45 borrowers as of Dec. 31, from 54 borrowers as of Sept. 30, the highest reading since LCD started tracking this data in 2013. The latest reading is roughly on par with the second quarter and up markedly from the year-end 2019 tally of 27.

Unsurprisingly, a greater share of former Weakest Links defaulted in 2020 than in the year prior. Indeed, out of the 145 names on the list at the end of 2019, 27% (or 39 issuers) defaulted by the end of the fourth quarter of 2020. This is roughly in line with the 2015 and 2016 Weakest Links cohorts, which saw a similar share default within one year.

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