July 30, 2020 - COVID is coming home to roost. Obviously, there have been devastating personal impacts as well as a record 32.9% annualized contraction in GDP. Closer to home in the loan market, there was a startling secondary price collapse and then recovery. More important, though, is what is actually happening to companies. We discuss both topics below.

In March, we saw loan prices fall 20-odd points as the U.S. shut down, loan investors demanded money back and selling pressures strongly outpaced what little buying demand existed. But then, starting late March, the secondary market turned on a dime. Over the past several months, average BB and B loan prices rallied more than 17 points; they now sit around 96.5 and 94.4, respectively, and are less than four points below their January highs.

But credit may not be so lucky. Regardless of the measure, COVID-impacted companies appear to be under significant stress. For instance, this week S&P/LCD wrote that their “Weakest Links” – loans rated B- or below and on negative watch – has swelled to 25% of their leveraged loan universe.  This is up nearly eight percentage points from the end of March, demonstrating the ferocity of rating agency downgrades after the pandemic hit the U.S. Indeed, as the COW demonstrates, the downgrade/upgrade ratio swelled to 43:1 in May as there were more than 400 downgrades and just a handful of upgrades. As the COW also shows, the downgrade/upgrade ratio typically leads the default rate. The S&P/LSTA Leveraged Loan Default rate sat at 3.7% by volume/3.88% by count on July 20th; Fitch has it pegged at 4.1% on July 29th. Either way, it is twice the level seen in January.

(As a side bar, it’s no better in private credit. Proskauer’s Private Credit Default Index’s default rate hit 8.1% in second quarter, up from 5.9% in first quarter. However, before hysteria strikes, it’s critical to note that these are not apples-to-apples default rates. Defaults in the Private Credit Index include “loans that have a payment, financial covenant or bankruptcy default, loans that are otherwise in default if the default is expected to continue for more than 30 days (excludes immaterial defaults) and loans that were amended in anticipation of a default.” In contrast, Fitch, Moody’s and S&P defaults typically include payment defaults, bankruptcy or distressed exchanges and not financial covenant defaults or amendments.)

So where are we likely to go? Fitch’s year-end 2020 leveraged loan default forecast continues to track toward 5-6%, and 2021 is penciled in at 8-9%. It’s not pretty out there.

Defaults and bankruptcies are bad enough; what would be really bad is that if there weren’t DIP financing available to help those companies reorganize (as has been theorized by some academicians). Fortunately, there does appear to be money for DIPs. According to Refinitiv, U.S. Debtor in Possession Financing already hit $10 billion this year. This already is the highest level since the financial crisis and, if the trend continues, we’re likely to top that unfortunate record.  

Do the stresses enumerated above allow lenders to demand higher rated credits and tighter documents? Well, perhaps not entirely. With many borrowers simply trying to get through the Coronavirus crisis, loan formation has slowed markedly and this has trickled through to holdings; outstandings in the S&P/LSTA Index sit at $1.18 trillion, down $13 billion from late March. In turn, with supply actually running below demand, investor appetite for acceptable deals is solid. Needless to say, more borrower-friendly technicals are impacting deal metrics. For one, Refinitiv reports that six B3 rated loans hit market in July, albeit with very wide margins, as deal flow remains limited. And then there are the doc trends. Covenant Review writes that “Old Normal” covenant terms returned in July. Specifically, CR rates documents on a scale of 1 (most protective) to 5 (least protective). In January, the average Documentation Score was 3.86, a recent high (which is bad). This improved to 2.91 in April, but loosened again to 3.84 by July. Part of this trend is illusory: April largely saw rescue financings, which required tight structures. But part of it is real: Stripping out rescue deals demonstrates that regular way deals also tightened in April and eased again by July.

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