From Hollow to Foam: The U.S. Leveraged Lending Market, One Year After COVID-19 Crash

We’re approaching a year from March 23, 2020, a pandemic-inspired low point in what would ultimately become a short-lived bearish credit cycle. The precipitous decline in the US leveraged loan market and the recovery that followed were both of unprecedented severity. A torrent of liquidity from the Fed has come full circle in the markets, and traditional markers of end-of-cycle exuberance and risk are rising at a time when defaults remain above historical averages and corporate debt remains close to historic peaks.

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So, a year after the stock market crash caused by the COVID-19 pandemic, LCD takes a look at the current state of the leveraged loan asset class in the United States.

Evaporation yields
As the COVID-19 crisis intensified, the weighted average bid price of the leveraged loan index plunged from 95.18 on February 29, 2020 to 76.23 on March 23, 2020. Fast forward by one year to February 28, and secondary loan prices not only fully rebounded, but held 260 basis points above the previous year’s mark of 97.78. It also marked the highest reading since November 2018 and reflected a 159 basis point increase from the end of 2020.

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On the other hand, the yield to maturity of the index’s loans fell in February to its lowest level since April 2004, at 4.33%, only 8 basis points above the historic low. of 4.25% in March 2004. The current level is about 40 basis points below the end of 2020 reading and is far from the pandemic peak of 12.87% last March.

Of course, from a relative value perspective, the liquidity injected into the system by the Fed and the very low Treasury rates resulted in low returns in the credit markets. In the high-yield asset class, which took market share in leveraged loans last year, secondary market returns hit a record high on February 16, at just 3.86 %. According to the S&P US High Yield Corporate Bond Index, this is the first time that the worst-case return has fallen below 4%.

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Irrational exuberance?
In this context of evaporating yields and in the face of the greatest monthly supply shortage on record, as measured by LCD, credit investors have turned this year to riskier offers, those historically considered to be markers of behavior at the top of the cycle. These include venturing lower in the capital structure to second-tier loans, funding loans from lower-rated borrowers (which is happening at an all-time high), and lending to businesses to fund. dividends from private equity sponsors. Investors have also had to admit a surge in loan revaluations – another hallmark of a sparkling credit environment. By lowering the cost of funds for an issuer, the returns realized to the lender / investor also decrease, of course.

According to LCD, the loan market recorded $ 140.1 billion in re-pricing this year through March 14, an increase of 22% from last year’s pace and nearly matching the $ 144 billion seen on the entire first three months of 2018.

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Despite lingering concerns about the overall deterioration of credit and the ability of companies to service debt in an economy constrained by the pandemic, 42% of borrowers financing in the US leveraged loan market so far this year. years held a relatively risky B-minus rating – just a cut above the vulnerable triple-C band by default – by at least one agency.

Meanwhile, in another illustration of foamy conditions, the issuance of second-tier loans, which are subordinated in the event of default to the issuer’s senior debt tranches, soared to $ 9.6 billion. in the year leading up to March 14, according to LCD.

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This overtakes a similar activity in 2018, when earnings and the economy as a whole were much stronger. As with B-minus rated issues, the cost of borrowing on these loans has fallen to its lowest level since before the Great Financial Crisis.

Another indication of risk appetite, loans backed by dividend recapitalizations have had one of the strongest starts in years. The volume of new dividend-related issues for companies owned by private equity firms reached $ 14.6 billion from 2021 to March 14.

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This is the second-highest tally for the period since LCD began tracking this metric 20 years ago, behind just 2017. It accounts for 16.5% of total leveraged news loan flows. issues to sponsored borrowers during this period, also the highest rating. since 2017.

Despite the record $ 61 billion in institutional loan issuance in February, the aforementioned wave of opportunistic operations comes against a backdrop of severe supply / demand imbalance that strongly favors issuers.

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The recent positive tailwind in underlying long-term Treasury yields, which eventually climbed from lows, has helped encourage some $ 150 billion in institutional loan issuance so far this year (so far). ‘as of March 14), which is slightly lower than the US record high of $ 151 billion during the same period in 2017, a year that saw a record $ 503 billion in institutional loan issuance. Institutional loans are of the type purchased by CLOs and retail investors through mutual funds and ETFs.

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But that activity comes after issuance ended down 7% in 2020, to $ 289 billion. Additionally, most of this year’s activity comes from repricing – which doesn’t count as new money transactions – as well as refinances and recaps, where new debt typically replaces existing debt.

By the end of February, the nominal stock tracked by the index had contracted by $ 16.4 billion this year, meaning that not all loans issued over that period were fully covering repayments, leaving no net supply.

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This brought total US leveraged loans outstanding to $ 1,188 trillion, the lowest figure since October 2019.

Again, combining this with the measure of demand for LCD in the leveraged loan market (issuance of secured loan bonds plus retail cash flow to US loan funds), the supply shortage in February hit a record high of $ 24.6 billion.

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Lack of distress
Thanks to the favorable market conditions which have allowed troubled companies to prove that they have access to liquidity by financing themselves on the leveraged financial markets and to the scores of companies guaranteeing room for maneuver on credit conditions , the share of loans valued in technical difficulty, ie less than 80% of the nominal value – fell to 1.53% at the end of February. This is the lowest end-of-month reading since September 2018. The share below 70 is almost non-existent, with just 0.43% of loans below that level. At the peak of March 23, 2020, 57% of loans were below 80 and 15% below 70.

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High default values
Ultimately, the leveraged loan market remains in a cycle of default and leverage is still near record highs.

The 12-month default rate of the S & P / LSTA Leveraged Loan index fell to 3.25% on the way up in February, from 4.17% in September. September’s level was the highest in the current cycle of above-average defaults.

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Nonetheless, without a new wave of new bankruptcies and defaults, the default rate could fall below the historic average of 2.9% in a matter of months. April through July has been a particularly active period of default activity in 2020, and $ 30.8 billion in defaults are expected to void the calculation over the next few months.

Hypothetically, calculating from February’s stock in the index (excluding defaults), this would take 267 basis points off the default rate of 3.25%, assuming there are no new defaults. .

Credit deterioration
This lack of distress arises despite the fact that the loan market exhibits a significant deterioration in rating quality in the broader index – a trend exacerbated by the downgrade cycle inspired by the 2020 pandemic and, more recently, a record rate of loan issuance from the B rating cohort.

The share of B-minus issuers in the S & P / LSTA leveraged loan index was an all-time high of 24.7% as of February 28, and 33.4% of loans were rated B-minus or less. This represents nearly $ 400 billion in outstanding loans. CCC loans or below now represent 8.6% of the index, down slightly from 11.2% at last year’s high, but up from just 3.6% in December 2015.

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On a more granular level, when looking at the average leverage of debt on EBITDA of public companies in the S & P / LSTA index, the leverage, at 6.16x in Q3 2020, eased from a record 6.41x in the second quarter. quarter, but was above the six-fold leverage limit adopted by regulators in 2013 to limit subprime lending.

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Public ranking of companies in the index at the “outer limit” of credit metrics, which might have less margin of error (companies with leverage greater than 7x and cash flow coverage less than 1, 5x), indicates a possible turn ahead. Among the public companies in the index, 32% had a leverage of more than 7 times in the third quarter of 2020, compared to only 16% in the third quarter of 2019.

Nonetheless, while 22% of companies maintained cash flow coverage below 1.5x, this is an improvement from 26% the previous year and significantly better than where this metric was before the Great Financial Crisis, when 37% of issuers at the end of 2007 were operating with cash flow coverage below this critical threshold.

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Priscilla C. Carnegie