With the bull cycle for corporate earnings already on shaky ground amid trade tensions and Brexit concerns, the latest quarterly EBITDA numbers indicate that issuers in the high-flying U.S. leveraged loan market could be at risk of a clattering fall.
EBITDA growth of S&P/LSTA Loan Index constituents that file results publicly tumbled to 3% in the first quarter of 2019, down from 10% in the fourth quarter of 2018 and from lofty 9%–13% growth rates over the four quarters of 2018.
EBITDA growth in the latest quarter was the softest since the first three months of 2017. The slide in core earnings came as top-line revenue growth for the sample moderated to 6%, marking a third consecutive sequential decline, from 14% growth in the second quarter of 2018. There were notable declines in year-over-year EBITDA performance in several cyclical sectors — including automotive, chemicals and materials, and oil & gas — and broad declines on a sequential basis.
The sample includes 196 issuers that account for approximately 19% of the index, by par amount outstanding. As of April 30, the index totaled $1.185 trillion.
After taking the temperature of the earnings season three months ago, analysts continue to see the Fed’s capitulation on further inflation-fighting rate hikes — and possibly additional accommodation down the road — as a salve for earnings as they chafe against strong trailing comps. Even so, for leveraged loan research analysts at Bank of America Merrill Lynch, the loss of top-line momentum coming into 2019 indicated that "the barrage of macro headwinds which markets have faced, trade war being the frontrunner, has now started affecting issuer fundamentals," with sliding small-business confidence indicators a canary in the coal mine. The knock-on confidence effects range from more cautious capital outlays by businesses, to reduced investor risk appetites.
Those concerns are borne out when taking a higher-level view of the earnings trajectory for corporate America. Earnings-per-share growth across the broader S&P 500 in the first quarter toppled to 2%, from 15% in the fourth quarter of 2018, and from growth rates of 23%–29% over the first three quarters of 2018 as tax policy provided a brisk tailwind to the results. Projected growth rates for the middle two quarters of 2019 are even more subdued, at plus or minus 1%, according to S&P Investment Advisory Services.
For now, even modest EBITDA growth, from the historically high base, is keeping the lid on corporate leverage. Average leverage for the loan-issuer sample touched a postcrisis low of 4.76x in the fourth quarter of 2018, and ticked up a modest 15 bps in the first quarter this year, to 4.91x. That level remained below the 5.1x in the first quarter of 2018, and an average reading of 5.23x over the last five years. On a weighted-average basis, leverage at 5.26x in the first quarter was up only five basis points sequentially, while holding 54 bps below the trailing five-year average.
Similarly, average cash-flow coverage of outstanding loans dipped in the first quarter — to 3.4x from 3.6x in the fourth quarter of 2018 — but held above a five-year average of 3.3x. On a weighted-average basis, the 3.3x reading in the latest quarter was firm sequentially and marked a long-term high, versus an average of less than 2.9x over the last five years.
Additionally, the proportion of "outer-edge" reporters — those exposed to the highest leverage and weakest coverage metrics — increased only slightly from the cycle lows at the end of 2018. The percentage of loan issuers with debt/EBITDA leverage of more than 7x increased a full percentage point sequentially, to 15.4%, but held comfortably below the 16.6% reading in the first quarter of 2018.
Issuers with cash-flow coverage of less than 1.5x ticked higher to 19.5%, from 18% sequentially and from 19.2% in the year-ago quarter. However, that percentage was materially higher three years earlier, at 27.4%, and averaged 22.5% over the interim period.
LCD’s latest survey of portfolio-manager sentiment, published April 1, continued to point to a low level of immediate concern regarding defaults. Portfolio managers, polled after the Fed’s surprise dovish move on rate and balance-sheet policy, provided a consensus forecast for the U.S. loan default rate at 1.82% for the end of March 2020, a 30 bps reduction from the previous quarter’s 12-month forward read. As for the end of December 2020, the consensus estimate was 2.58%, down from the consensus estimate of 2.79% in the December 2018 survey, indicating slightly more bullish sentiment.
But the Fed is holding a double-edged sword, as its dovish crouch may inhibit retail loan demand and ultimately cut off funding avenues for some credits. To wit, respondents in the latest survey shortened their timeline for when loan defaults could finally move above the 3.1% historical average, with 75% predicting that this will occur in 2021, up from 42% at the previous read.
More telling, 25% of investors in the December 2018 read believed loan defaults would remain below the historical averages until at least 2022. Just three months later, no respondents in the latest survey expected it would take that long. — John Atkins