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Earnings at leveraged loan issuers nose higher, though cash flow coverage dips

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Earnings at leveraged loan issuers nose higher, though cash flow coverage dips

Issuers of U.S. leveraged loans again posted higher year-to-year core earnings in the third quarter, prolonging a superannuated growth cycle that many had feared would thud to a halt in 2019 under the weight of trade squabbles and faltering global-growth indicators.

Even so, earnings trends appear to be losing the power to hold an effective lid on bubbling late-cycle credit measures.

EBITDA growth across S&P/LSTA Leveraged Loan Index issuers that file results publicly was a mild 2.5% in 2019's third quarter, and was 1.7–2.7% over the first three quarters this year. That marks sharp deceleration from 9–13% growth rates over the four quarters last year, according to LCD. Similarly, third-quarter revenue growth was 6% across the sample, steady versus 5% in the second quarter and 6% during the first three months of 2019, in a downshift from 9–14% quarterly growth rates in 2017 and 2018.

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As growth trends sputter, aggregated total leverage for the 190-issuer group that reports publicly, on a weighted average basis, ticked to 5.7x in 3Q19, marking a third consecutive increase, from 5.2x in 2018's fourth quarter. That leverage measure had moved smartly lower, by more than three-quarters of a turn, through the high-growth earnings results over the trailing two years.

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And coming into sharp relief in the latest quarter was a marked erosion in cash flow coverage for the group. The weighted average for that measure tumbled to an 11-quarter low of 2.7x in 3Q19, down from 3x in 2Q19, and 3.3x in 4Q18 and 1Q19.

In 2018 and early this year, market defenders would often point to what was relatively lofty cash flow coverage and interest coverage at U.S. loan issuers to counter market bears, who said the red-hot loan segment was ripe for a fall.

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Those 190 public filers in the sample account for $192 billion, or 16%, of the performing loans in the S&P/LSTA Index as of Sept. 30, 2019, down from 202 issuers at the 2Q19 reading. Across the issuers whose results LCD captured in both the 2Q and 3Q readings, cash flow coverage tumbled to 3.07x in 3Q on that apples-to-apples basis, from 3.22x in 2Q, indicating unambiguous slippage in discretionary cash flow to bolster debt-management efforts.

Further, the number of credits most thinly protected against shocks is on the rise. The proportion of issuers, across all 190 reporters, with cash-flow coverage of less than 1.5x vaulted to 26% in the latest quarter. That share of "outer edge" issuers increased by nearly five percentage points, versus the second quarter, marking a three-year high.

Issuers at the outer-edge for leverage—those at greater than 7x—moderated to 16.2% in the latest quarter, from 18.3% in the second quarter. However, both readings were up from a low of 14.4% in the fourth quarter last year.

Coming into the third quarter, few portfolio managers expressed undue concern over the fundamental health of the loan markets. Better than nine in 10 managers surveyed in LCD's quarterly poll, conducted in September, believed loan defaults would continue below the 2.9% historical average past 2020, including 27% that thought defaults would continue below that threshold until at least 2022.

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The surprising vigor of corporate earnings in the third quarter against stiffening headwinds validates, for now, a measured take on near-term risk factors. Among S&P 500 Index constituents reporting calendar third-quarter results, roughly 75% of the group posted higher-than-expected EPS results, according to S&P Global Market Intelligence. The aggregated upside surprise was 6.1% above analyst projections, and more than one-third of the reporters posted year-over-year EPS growth of at least 10%.

Eight of the 11 sectors comprising the S&P 500 Index produced aggregated year-to-year EPS gains, all in single digits, led by nearly 9% growth for Healthcare. The three decliners were led by Energy (down 39% year to year), followed by Materials (down 20%), and Information Technology (down 3%).

Stiff upper lips for managers of leveraged loan portfolios notwithstanding, credit quality trends are sounding alarms in key markets, including for CLOs, where many structures carry triggers when a too-high proportion of their constituent issues fall to the triple-C tier. In that context, the ratio of ratings downgrades to upgrades across issuers in the S&P/LSTA Index rose to 3.05x for the 12 months through October, the highest reading since November 2009, and up from 2.1x in 2018 and 1.6x in 2017, according to S&P Global.

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Already, the generally solid third-quarter results had to stand up to some loud detonations within at-risk categories. Aggregated leverage for the B– ratings bucket was 7.4x in the third quarter, but would have been steadier relative to 2Q, near 7x, if Diplomat Pharmacy—which drew a downgrade review for its B– rating after it slashed EBITDA guidance and warned on covenant headroom—was excluded from the sample.

And, within the single-B ratings bucket, 59% of the reporters that were part of both the 2Q and 3Q samples this year posted higher leverage on a sequential basis. Camping World skidded into the category in August on an S&P Global Ratings downgrade, related to lowered guidance, which the agency projects will keep the company's adjusted leverage above its 5x downgrade threshold for a B+ rating through 2020.

This analysis was written by John Atkins, who oversees high-yield and investment-grade bond coverage for LCD.