- Diverging trends between benchmark rates and credit spreads in leveraged loan pricing in the majority of quarters over the past 15 years have kept loan funding costs in check.
- With the two metrics both trending upward in the current economic environment, increased loan funding costs will continue to affect new issuance.
- CLOs have supported the growth of the leveraged loan market while considerably increasing the acceptance of the 'B-' rating cohort.
The U.S. leveraged loan market has grown significantly in the last two decades. Based on the Morningstar LSTA Leveraged Loan Index, a proxy for outstanding institutional loans, the market has expanded to almost $1.4 trillion currently from about $100 billion in 2000. This growth has been fueled by the demand for broadly syndicated CLOs, which have attracted a lot of interest (and capital) due to their relatively rich spreads.
Investors' thirst for yield during a protracted period of low interest rates--coupled with a history of CLO performance--helped spur the growth of the asset class. U.S. CLOs have grown to roughly $850 billion from about $200 million in 2006, and they are estimated to account for over 60% of the loan market today compared to 40% during the Great Financial Crisis (GFC).
Leveraged Loans' Deteriorating Credit Profile
In the last few years, leveraged loan investors have stretched their threshold for risk tolerance, as the decline in the credit quality of issuers demonstrates. Of the names carried in the LSTA Leveraged Loan Index, the proportion of companies rated 'B-' by S&P Global Ratings went up by 174% to over 30.35% at the end of second-quarter 2022 from 11.09% in August 2016. Over the same period, the proportion of companies rated 'B+' and above, which had constituted about 41% of the index, has dropped to 34.12%.
The decline in the credit profile of companies has stemmed from the change in the dynamics of the market, with an increase in number of highly leveraged private equity-owned companies. CLOs and other loan investors provide a receptive market for highly leveraged loans typically issued for buyouts, M&As, dividend recapitalizations, or debt refinancing.
Related to the decline in issuer credit quality is a downward trend in recovery levels and recovery expectations. Based on a recovery study we conducted of companies that have emerged from bankruptcy since the GFC, recovery for first-lien debt among companies that emerged from 2018 to the first half of 2021 has averaged 70%, almost a 10-percentage-point decline from the recovery rates for the same debt category from companies that emerged between 2008-2017. The increase in the proportion of first-lien debt, which is cheaper to fund, and an erosion in level of subordinated or junior debt (the debt cushion available to senior lenders) have contributed to the expectation of reduced recoveries. The increase in covenant-lite loan structures is another factor contributing to our expectation of lower recoveries. Based on Pitchbook LCD data, 85% of the loans in the BSL market currently have a covenant-lite loan structure.
Low Interest Rates And Credit Risk Premiums Keep A Lid On Funding Costs
Traditionally, loans as an asset class have been an attractive investment, especially when interest rates are rising, as they are indexed to a reference rate (mostly LIBOR and--more recently--SOFR). U.S. LIBOR and SOFR track Federal Reserve policy rates, set by the Fed to keep inflation and employment at its target levels. Since the GFC, the three-month LIBOR breached 200 basis points (bps) in only six quarters--from the second quarter of 2018 to third-quarter 2019. Given the extended periods of low rates, the loan issuers often provided a floor, typically ranging from 50 bps-100 bps, that was the guaranteed minimum benchmark rate used to determine loan facility interest levels.
Credit spreads offered over the floating benchmark rate is the added risk premium that leveraged loan lenders command. Credit spreads are typically a function of macroeconomic conditions and generally reflect the level of credit and economic risk for which the lenders need to be compensated.
The chart at the end depicts the average three-month LIBOR (after consideration of floors, also averaged) and the quarterly average of term loan B spreads (as a proxy for credit premiums) based on LCD data going back to 2006 and through the second quarter of 2022. For the first two quarters in 2022, we have used three-month term SOFR averages, as most of the loans were priced off that given the change in ruling around the use of LIBOR. The SOFR rates, like the LIBOR rates, have been trending up. In the majority of the quarters for the period that we have tracked LIBOR and credit spreads, the two have moved in opposite directions. These divergent trendlines between the benchmark and loan spreads have helped to keep the cost of funding a loan in check (the two have a correlation of negative 0.5). The highest level of total interest observed since the GFC was in the first quarter of 2019, when the aggregate of average benchmark and credit spread was about 6.9% (4.25% credit spread over the 2.68% three-month LIBOR rate); this was one of the few quarters when the two moved up in tandem. This generally negative relationship is somewhat intuitive: A simple explanation is that in any economy buoyed by liquidity with high levels of risk capital, there is easy access to finance (for even low-rated issuers). The increase in availability of capital and the dynamics of demand will invariably lead to lenders willing to accept lower credit spreads, and the Fed will likely intervene to slow things down and remove the proverbial punch bowl through its regulation of policy rates.
In the data set that we reviewed, credit spreads were the lowest through the second half of 2007 in a heated market leading up to the GFC, at a time when Fed raised rates to slow the pace of the economy. Conversely, when there are macroeconomic concerns and financing conditions become a challenge, investors command a higher credit spread for the risk taken. The Fed will accordingly have an accommodating monetary policy and look to raise aggregate demand by reducing policy rates. The most recent example of this was in the second quarter of 2020, when the pandemic struck. The risk premium went up to 560 bps (a level last seen in 2009), while policy rates were lowered all the way to zero.
Leveraged Loan Issuers' Challenges Today And With New Issues
Based on headline inflation numbers this year, the Fed's view has turned more hawkish, causing it to accelerate rate hikes and signal more to come. The benchmark rates have responded accordingly, and the three-month LIBOR shot up to 2.8% now from 0.2% at the start of the year, while the three-month term SOFR rates are at 2.64%, up from under 0.1% at the start of the year. These rates will go up further given the Fed's aggressive tone regarding combating inflation. We expect the Fed Funds rate to go up to about 3.6% by the second quarter of 2023 (from 2.25%-2.5% today), with LIBOR (and SOFR) likely to shoot up similarly.
The Increase In Risk Premiums
The Russia-Ukraine conflict, which has put additional upward stress on already high commodity prices, coupled with China's economic shutdown has aggravated supply and cost pressures and cemented the view that inflation is persistent. The onset of high inflation and the expectation that it will continue have worsened financing conditions and consumer sentiment. Presently, concerns about rate hikes have amplified into more broad-based worries. In addition to earnings decelerating because of higher input costs, select sectors--such as retail and consumer discretionary--are feeling the result of slowing demand, as consumers are pulling back. Based on our quarterly review of the financial statements of speculative-grade companies since 2019, average earnings peaked in the second quarter of 2021, and growth has since slowed on average and turned negative for a few sectors, such as consumer products. The issue is compounded by the Fed's impending plan to unwind its balance sheet, which may further disrupt financial markets.
Investors will continue to demand higher risk premiums given the economic uncertainties. Benchmark rates and credit spreads have moved up in tandem in the last two quarters. It is likely that they will continue to move up given the uncertain economic environment and the trajectory of inflation. This combination will add significantly to funding costs for leveraged loan issuers.
This report does not constitute a rating action.
|Primary Credit Analysts:||Ramki Muthukrishnan, New York + 1 (212) 438 1384;|
|Omkar V Athalekar, Toronto +1 6474803504;|
|Secondary Contact:||Steve H Wilkinson, CFA, New York + 1 (212) 438 5093;|
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