The U.S. leveraged loan market in August completed its second straight default-free month, lowering the default rate of the asset class to a slim 1.29%, well below the historical average of 2.9%, according to the S&P/LSTA Loan Index.
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While that headline number seems innocuous, other metrics of loan issuer health are turning less benign.
Most notably, the distress ratio among these speculative-grade borrowers – as measured by the share of the $1.18 trillion in outstanding loan debt bid below 80 cents on the dollar – jumped to a roughly three-year high of 4.03% in August, from 2.81% the previous month, according to the Index.
That loan issuer distress is climbing while defaults remain scarce might seem counterintuitive. However, this dynamic reinforces a trend which has largely characterized the market since its rebound after the financial crisis of 2007-08: With the growing incidence of covenant-lite loans, along with other deterioration in credit documentation, borrowers today are better able to skirt technical defaults, even though their financial condition might have worsened.
Generally speaking, cov-lite loans include only incurrence covenants, where a borrower would need to be in financial compliance only if it undertakes a specific action, such as an acquisition. Traditionally structured loans include maintenance covenants, which are far more restrictive. They require a borrower to regularly meet financial tests, even if there are no actions pending.
As of Aug. 31, covenant-lite accounts for nearly 80% of all outstanding leveraged loan debt, according to LCD.
Not just distress
The rising leveraged loan distress ratio comes as credit conditions show other signs of softening.
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Most visibly, the U.S. leveraged loan market is getting riskier, judging by ratings. The share of outstanding loans rated single-B or below increased for a third consecutive month, to 48.41%, according to the Index. And the share of loans rated CCC+ or below now stands at 7.01%, its highest mark in two years.
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In another gauge of credit conditions, Index issuers posted razor-thin earnings growth for a second straight quarter in 2019, alongside another quarterly increase in aggregate leverage and decline in cash-flow coverage.
According to LCD's latest analysis, EBITDA growth across S&P/LSTA Loan Index issuers that file results publicly was a marginal 2% in the second quarter, down from 3% in the first quarter and 9% to 13% growth rates over the four quarters of 2018.
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Loan-issuer leverage, on a weighted-average basis, increased one-third of a turn from the first quarter — to 5.59x, from 5.26x — while cash-flow coverage declined 34 bps sequentially, to 2.95x.
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Deals in focus
Turning back to distress measures, with several restructuring situations playing out, the share of loans quoted below 70 increased to 2.03% from 1.82%, marking its highest point since November 2016.
Among loans priced at deeply distressed levels, film production concern Deluxe Entertainment Services Group Inc. reached a deal on the terms of a restructuring that will see the MacAndrews & Forbes Group Inc.-backed motion picture company hand control to term loan lenders in return for cutting its debt load by more than half, the company said in an emailed statement.
Under the terms of the RSA, Deluxe said it intends complete the offer to exchange all of its existing term loan debt for 100% of the reorganized company's common stock within the coming weeks.
Simultaneous with the launch of the exchange offer, the company will solicit its senior lenders to approve a pre-packaged plan of reorganization, which would be implemented only if the exchange offer does not have unanimous consent.
In a separately emailed statement, MacAndrews & Forbes spokesperson Josh Vlasto said: "MacAndrews & Forbes has been a proud sponsor of Deluxe for nearly 15 years. We have been fully supportive of the refinancing and restructuring process, however we have decided not to participate in the refinancing."
Deluxe's $782 million outstanding senior secured term due 2020 (L+550, 1% LIBOR floor) capitulated more than 80%, to a high-teens context, after the company disclosed in late July that it had abandoned plans to spin off its Creative Services division, the proceeds of which, along with a debt-raising effort, had been pegged to repay a sizable amount of the company's term loans and ABL borrowings. The company at the same time announced the placement of a new, $73 million delayed-draw term facility, further pressuring pricing on the term loan.
In connection with the takedown of the term loan, Deluxe agreed to meet certain milestones related to a comprehensive deleveraging transaction that might involve a possible exchange to be completed by Sept. 26, 2019.
Fellow loan-only issuer Clover Technologies was hit with a three-notch downgrade to its issuer credit rating, to CCC, due to the probability that the company will pursue a restructuring of its debt obligations.
Also known as 4L Technologies, the recycler of mobile phones and inkjet cartridges instructed lenders to organize with their own advisors as it guided pro forma annualized consolidated EBITDA at $87–96 million—materially lower than EBITDA of $140 million in 2018.
The company's $694.5 million term loan due 2020 (L+450, 1% LIBOR floor) lost half its value in the days following the news, with the moves exacerbated by illiquidity and price discovery amid markedly lower recovery expectations.
"We estimate revenue from the two key customers to be approximately $250 million, a major setback that is exacerbated by significant pricing pressure on both the wireless and imaging segments given the increasingly competitive landscape," S&P Global Ratings analyst Kevin Cheng said in a July 16 report.
"Given the upcoming term loan maturity in May 2020 we see material risk of 4L attempting to restructure its debt obligations within the next 12 months," Cheng wrote.
Among other companies with loans priced below 70 is Murray Energy. Barely a year after completion of its 2018 distressed debt exchange, the company was downgraded by S&P Global Ratings to CCC, from CCC+, citing S&P's view that Murray will likely consider a distressed exchange within the next 12 months, given the deep discount of its secured debt.
The company's capital structure consists of $1.7 billion of outstanding superpriority term loans due in 2022—a constituent of the Leveraged Loan Index—$479 million outstanding of 1.5-lien notes due in 2024, and $295 million of second-lien notes due in 2021. The company also has $2 million in second-lien notes and about $51 million in term loans remaining of its B-2 and B-3 term loans due in 2020 that did not participate in the exchange transaction in June 2018.
Finally, Team Health Inc.'s $2.75 billion B term loan (L+275, 1% LIBOR floor) is wrapped around either side of 80 following news last month that it could lose its in-network status with United Healthcare.
Moody’s lowered its outlook on Team Health's B3 corporate credit rating to negative, citing rising uncertainty around the company's ability to reduce leverage given its recently disclosed dispute with UnitedHealth Group, one of its largest commercial payors.
"UnitedHealth notified Team Health in July 2019 that it will terminate approximately two-thirds of its in-network contracts with Team Health between Oct. 15, 2019 until July 1, 2020," Moody’s analyst Kailash Chhaya said in a report on the issuer.
"The company also said that UnitedHealth had significantly reduced its payments to Team Health for out-of-network services," Chhaya writes.
Other first-lien loans quoted below 70 include Pier 1 Imports Inc., Acosta Inc., Academy Sports, Ascena Retail Group Inc., Serta Simmons Bedding LLC, and American Commercial Lines LLC.
