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Leveraged loan issuers' earnings keep debt-service ability strong, for now

Despite ongoing concerns from regulators about the high-flying U.S. leveraged loan asset class, issuers in that sector once again posted impressive earnings, leaving them well positioned to service debt, for now at least.

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During the fourth quarter of 2018, EBITDA growth at leveraged loan issuers topped 10%, following a seven-year high of 13% growth in the third quarter, according to LCD. This earnings performance has been consistently strong over the last year, including rates of 9% in the first quarter of 2018 and 12% in the second. The fourth-quarter growth reflected a 9% expansion of top-line revenue and 6% asset growth.

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This sample comprises borrowers underlying the S&P/LSTA Leveraged Loan Index that file publicly (that is 189 issuers accounting for approximately 18% of the roughly $1.17 trillion of outstanding U.S. leveraged loans).

This stubbornly strong performance by loan issuers comes as the asset class continues under scrutiny from regulators and market watchers alike. Chief among regulator concerns is the dominance of the covenant-lite loan structure and, more recent, the prominence of collateralized loan obligations, or CLOs, a critical component of the leveraged loan investor base.

Still-rising tide
The loan-issuer results come alongside broad growth across corporate America. With most of the earnings in as of last week, S&P 500 companies were on track for 15% EPS growth on a blended basis during the fourth quarter, according to S&P Global Market Intelligence. With 494 of the S&P 500 companies reporting, 69% of posters beat Street consensus forecasts, driving the aggregate result across all constituents to a roughly 5% upside surprise. Further, 56% of the sample posted double-digit or better year-to-year growth, while 26 companies reported growth of more than 100%.

S&P Global Market Intelligence noted outsized sector gains for Energy (+81.9%), Real Estate (+32.4%), and Industrials (+20.0%). Laggards included Communication Services (-22.1%), Utilities (-10.4%), and Consumer Staples (+1%).

Nevertheless, the trailing strong gains in the wake of tax reform will weigh on comparisons in the current quarter. For the first quarter, S&P Global Market Intelligence's projected blended growth rate for the S&P 500 is negative 1.9%, propped up by Healthcare, Industrials and Financials, which are tracking for relatively modest 2%-5% growth. Projections do suggest improvement later in the year, but only to modestly positive 1%-2% growth rates for the middle two quarters (after 25-29% growth for the same 2018 periods). The early view for the final quarter of 2019 is a return to more robust growth, near 9%.

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Loan strength
At least for 2018, EBITDA trends were a clear positive for loan-issuer credit metrics. Weighted-average leverage across the constituents continued lower, to 5.2x, down 0.07x sequentially and 0.66x year over year, according to LCD. Leverage hasn't been lower since the EBITDA bubble days of early 2007.

Meanwhile, cash-flow coverage on a weighted basis increased another eight basis points sequentially and more than half a turn year to year. As was the case in 2018's third quarter, both the weighted-average reading (3.3x) and straight-average reading (3.6x) marked fresh heights for records kept since 2001.

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Interest coverage, on a weighted-average basis, held at a record high of 4.6x in the fourth quarter, from 4.2x a year earlier and 3.8x for the final quarter of 2016. Interest coverage is a key metric in the leveraged loan market as it indicates how well a company is positioned to pay interest on outstanding debt. Loan market observers are keeping a careful eye on the figure, especially if corporate earnings have indeed peaked, as some have suggested.

Amid windy conditions across distressed debt ratios over the last two quarters the proportion of credits with the weakest, "outer-edge" leverage and cash-flow characteristics continues at notably low levels. Loan issuers with debt-to-EBITDA of greater than 7x ("outer-edge" credits) represented roughly 14% of the pool in the fourth quarter, down nearly 5.5 percentage points year to year and setting a new low for this exceptionally protracted credit cycle. The share of issuers with cash-flow coverage of less than 1.5x also tumbled to a new low of 18%, down 2.5 percentage points sequentially, while adding distance from a 23% reading in the fourth quarter of 2017.

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Despite the harrowing losses across the leveraged finance segment over the final six weeks of 2018, institutional investment managers continued to take a measured approach to assessing the end of the credit cycle. In LCD's final 2018 survey of loan-portfolio manager sentiment, conducted during the teeth of the December sell-off, no respondents expected the U.S. leveraged loan default rate to breach its 3.1% historical average in 2019, after more than one-third pegged a breach this year, per the final survey of 2017, conducted toward the end of that year.

Indeed, the U.S. leveraged loan default rate this week hit a seven-year low of 0.93% after iHeart communications dropped off the rolling 12-month default sample. When iHeart defaulted in March 2018 it did so with $6.3 billion in outstanding loan debt, making it one of the largest such bankruptcies ever.

Further, 42% do not see a breach in the historical rate until 2021, and 17% see it as a 2022 event. Additionally, and for the first time, a small 8% contingent suggest that defaults will continue below the historical average for the foreseeable future.

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That constructive view was met with concurring price action in January and February, as loan bids rallied strongly from the lows.

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Trailing conditions notwithstanding, market participants and observers remain keenly aware of how quickly sentiment can shift. S&P Global economists Beth Ann Bovino and Satyam Panday, in S&P's February U.S. Business Cycle Barometer update, noted existential angst linked to the glaring rise of BBB debt in investment-grade indices and the record heights for the share of covenant-lite leveraged loans, especially as private equity sponsors push debt multiples "beyond the Fed's threshold of six."

And then there's covenants.

"Deteriorating quality, loosening protection for investors, and the Fed's lack of tools to rein in nonbank credit combined will not end well if things start to go wrong under the increasingly restrictive financing conditions," Bovino and Panday said.