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US leveraged loan Weakest Links decline as downgrades stabilize

The pace of credit ratings downgrades has stabilized in recent months and, as a result, the count and share of U.S. leveraged loan Weakest Links retreated in the third quarter, after hitting the highest level in at least eight years in the second quarter of 2020. Despite this decline, both metrics remain roughly double the levels recorded at the end of 2019.

As of Sept. 30, at the end of the second full quarter since the onset of the coronavirus pandemic, the number of leveraged loan Weakest links, as tracked by LCD, fell to 295 issuers, down from 329 in June — that 329 was the highest reading since LCD began this analysis in 2013. However, the count remains elevated relative to 227 in March and more than double 145 at the end of 2019. As a result, the loan Weakest Links share inched lower, to 22.5% as of September, from 25% in June, but remains well above 17% in March and 11% in December.

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(Note that 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.)

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. While defaults rose in the third quarter, this was not the main driver behind the overall decline in the Weakest Links. Eleven of the borrowers on the Weakest Links list in June have been downgraded to a D or SD rating by the end of September, with the majority becoming stressed prior to the onset of the COVID-19 pandemic. Seven of these 11 companies have been on LCD's list of Weakest Links for two years or more.

As a result, the share of defaults and restructurings in the ranks of Weakest Links rose to 54 borrowers as of Sept. 30, the highest reading since the start date of this analysis, in 2013, up from 44 at the end of the second quarter and double the year-end 2019 tally of 27.

Again, the majority of these 54 borrowers were on the list of loan Weakest Links prior to the onset of the COVID-19 pandemic. Some notable exceptions include Cirque Du Soleil Canada Inc., Men's Wearhouse, Hertz Global Holdings Inc., CEC Entertainment Inc. and Garrett Motion Inc.. These borrowers were not in the Weakest Links cohort at the end of 2019 due to a B or higher rating or a stable outlook from S&P Global Ratings.

On a positive note, the biggest driver of the decline in Weakest Links in the third quarter was the improvement in outlook on 35 issuers. While these companies are still rated B- or CCC+, the majority now have a stable outlook.

In addition, the pace at which loan borrowers are becoming Weakest Links has slowed markedly in the last quarter, as the downgrade wave subsided. LCD added 18 issuers to the cohort in 2020's third quarter, including seven which joined as a result of a downgrade to B- or lower (with a negative outlook), such as Peabody Energy Corp., Altisource Solutions Inc. and Ryman Hospitality Properties Inc. To put this number into perspective, 137 borrowers joined the Weakest Links in the second quarter, including 63 which were added as a result of a one-notch downgrade to B-.

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The pace of ratings downgrades had retreated to pre-COVID-19 levels by the end of September, with the rolling three-month ratio of downgrades to upgrades falling to 3.1x from the stratospheric 43x in May and 18x in June. In fact, the current reading is below the year-end 2019 level, at 3.4x, although it's elevated relative to the 2.3x average seen between 2017 and 2019.

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As a result, the share of all issuers in the S&P/LSTA Leveraged Loan Index rated B- or lower has inched slightly lower in each of the last three months, to 32% on Sept. 30, although it remains close to the 34% record high in the second quarter of 2020 (by par amount outstanding). With that said, the current level is significantly above 28% at the end of March and 24% a year ago. Issuers falling into the C to CCC+ range now account for 10% of the index, down from 11% in June but up from 7.5% in March and 6% a year ago.

The effect of COVID-19-related downgrades and worsening outlook spread across all sectors this year. The highest number of Weakest Links belongs to Electronics/Electric (LCD's proxy for the technology sector), Healthcare, and Business equipment/Services. These sectors are also the three biggest industries in the loan market overall, collectively accounting for about a third of the $1.2 trillion institutional loan market, based on the S&P/LSTA Leveraged Loan Index. Therefore, their leading position among the Weakest Links is in line with their overall presence in the loan market.

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In contrast, Entertainment & Leisure and Industrial Equipment sectors saw a large spike in Weakest Links this year, compared to last year. Retail, a sector which has dominated the corporate default landscape in recent years, saw a reduction to 4%, more in line with its overall share in the loan market, down from 9%. Most of the retail borrowers have been on investors' distress radar for a while now. Indeed, seven out of the 54 defaults in LCD's analysis come from the retail sector.

At the end of the third quarter, the U.S. leveraged loan default rate, by issuer count, rose to 4.64%, the highest level since August 2010. As a result, a greater share of former Weakest Links have defaulted. Indeed, out of the 145 names on the list at the end of 2019, 25%, or 36 issuers, defaulted by the end of third quarter of 2020. The sharp increase in Weakest Links in 2020 suggests a heightened risk of default down the line.

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