US leveraged loan Weakest Links count falls below pre-pandemic level

Favorable funding conditions for lower-rated companies and a strengthening U.S. economy have reduced the number of U.S. leveraged loan Weakest Links below pre-pandemic levels.

By the end of June, the number of leveraged loan Weakest links, as tracked by LCD, fell to 143 issuers, slightly below the 145 at year-end 2019, with the Leisure sector topping the list. This was the fourth consecutive quarterly decline from the pandemic-era peak of 329 in June 2020, and the biggest quarter-over-quarter reduction (as a percentage change) during this period.

As a result, the share of loan Weakest Links declined to 10% as of June 30, the lowest level since the end of 2018, when it was 7% and a sharp drop from the 25% peak in June 2020.

LCD's loan Weakest Links are loans in LCD's universe that have a Corporate Credit Rating of B-minus 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.

The universe of loan Weakest Links shrinks when more loans exit the cohort — either due to a 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 second quarter was the improvement in outlook on 44 issuers. While these companies are still rated B-minus or triple C, the majority now have a Stable outlook.

The pace at which loan borrowers are becoming Weakest Links slowed markedly as upgrades began to overtake downgrades this year.

In the second quarter of 2021, the ratio of upgrades to downgrades in the S&P/LSTA Leveraged Loan Index rose to 2.3x, the highest reading since May 2012, and remained at that level in the three months ended July 31. In fact, LCD added just six issuers to the Weakest Links cohort in 2021's second quarter, including Endo International PLC and Topgolf International Inc. To put this number in perspective, a whopping 137 borrowers joined the ranks of Weakest Links in the second quarter of 2020 amid a pandemic-induced wave of downgrades.

However, many of the pandemic-era Weakest Links were temporary — out of 329 names on the list at the peak in June 2020, 153 borrowers were not in the cohort before December 2019 and are not in the cohort now. The improving U.S. economic recovery has played a role here, as have favorable funding conditions for lower-rated companies, allowing issuers to manage near-term maturities and/or lower the borrowing costs.

Indeed, in the first half of 2021, issuers rated B-minus raised $79.3 billion in the leveraged finance market to refinance existing debt. This tops the full-year tallies for 2020 ($55.1 billion) and 2019 ($32.9 billion). (The analysis is based on borrowers rated B-minus or B3 by at least one rating agency.)

This refinancing activity made a significant dent in the near-term maturities of B-minus borrowers, as tracked by the S&P/LSTA Leveraged Loan Index. A year ago, $54.3 billion of B-minus loans were due by the end of 2023. By July 2021, this figure was just $11.1 billion. Maturities through the end of 2024 were cut in half, from $121 billion to $61.8 billion.

Lower-rated borrowers have managed to reduce the volume of debt coming due in the next few years as the overall size of the B-minus universe ballooned to an all-time high, at 25% of all loans tracked by the Index on June 30. As demand for higher-yielding assets rose this year, the share of new-issue volume from this ratings bucket spiked. In fact, LCD tracked $156 billion of issuance from borrowers rated B-minus by at least one rating agency in the year to Aug. 3, more than any full-year tally on record.

Leisure tops the list

The effect of COVID-19 related downgrades and worsening outlook spread across all sectors last year. By June 2021, some industries returned close to pre-pandemic levels in terms of risky borrower concentration, while others remain elevated relative to December 2019. Only two sectors — Leisure and Cosmetics/Toiletries — have expanded the ranks of Weakest Links since the pandemic-era peak in June 2020.

LCD tracked 19 Leisure names in June 2021, two more than in June 2020 and 16 more than before the onset of COVID-19. This cohort expanded rapidly on the back of downgrades related to social-distancing measures during the pandemic. At the end of the first quarter of 2021, Leisure took over the leading position in the Weakest Links cohort, displacing Electronics/Electric (LCD's proxy for the technology sector), the biggest sector in the loan market overall.

Retail and Oil & Gas, two sectors that dominated the corporate default landscape in recent years, now have fewer Weakest Links than they did at the end of 2019. Most of these borrowers have been on investors' distress radar for a while now and shifted to the default category last year.

Overall, the count of defaults and restructurings in LCD's Weakest Links analysis retreated to 15 borrowers as of June 3, the lowest reading since 2015. Recall that the count reached 54 borrowers as of Sept. 30, 2020, the highest reading since the start date of this analysis, in 2013.

More broadly, the default rate of the S&P/LSTA Leveraged Loan Index fell to just 0.58% in July, the lowest level April 2012, according to LCD data.

With the credit markets awash with liquidity, the rate at which Weakest Links become defaults has slowed dramatically. Less than 1% of 2020 year-end Weakest Links have defaulted so far in 2021, and with the Index distress ratio at just 1%, this share is not expected to increase dramatically in the near term. In contrast, the year-end 2019 cohort did not hold up as well, with 27% of these borrowers defaulting in 2020, as risk appetite for lower-rated borrowers evaporated at the onset of the pandemic. Looking at the five years before the onset of the pandemic, roughly 20% of Weakest Links were downgraded to a D or an SD rating in the following year.