June 17, 2021 - by Meredith Coffey. It’s the old good news/bad news story. On the good news side, the credit outlook for leveraged loans has improved dramatically as measured by a plethora of metrics. On the bad news side, the improved credit outlook combined with strong lender demand is, not shockingly, leading to more aggressive credit terms.
First, it is remarkable how much the credit environment has improved in a year. From a market perspective, S&P/LCD reported that the spec-grade US distress ratio dropped to 2.6% in May. This is down from 2.9% in April and, far more impressive, down nearly 33 percentage points from March 2020. (In other words, in the early days of the pandemic, more than 35% of spec-grade issues had spreads over 1,000 bps due to the sharp decline in asset prices.)
Now, market prices (and, hence, spreads) can be swung by sentiment and technical factors, but actual default forecasts have fallen materially as well. Fitch expects its trailing 12-month default rates for loans and HY bonds to be 1.9% and 2.0%, respectively at the end of June. The firm has further reduced its year-end 2021 default rate forecasts from 2.5% to 1.5% for leveraged loans and from 2.0% to 1.0% for HY bonds. For what it’s worth, these are 10-year lows. While Fitch notes that accommodative monetary policy has supported market access for spec-grade companies, the benign default environment is not solely dependent on federal policy and short-term rates remaining historically low.
Falling defaults certainly have benefited US CLOs, which have seen their total volume of defaulted loans drop to $3.18 billion in May, according to LPC Collateral. The biggest defaulting sectors are Oil & Gas ($790 million or nearly 25% of defaulted volume), Healthcare ($509 million) and Retail/Supermarkets ($324 million). How does this compare to historical trends? A lively (and fun!) chart by Refinitiv tracks the changing volume of defaulted industries in CLOs over time. Long story short, Oil & Gas plays a recurring role as default villain, even though it only accounts 2.73% of the S&P/LSTA Leveraged Loan Index according to the LLI Factsheet.
Perhaps unsurprisingly, with default rates falling and lender appetite rising, leverage multiples are climbing again as well. According the Covenant Review and LFI, after falling to a one-year low of 4.2x first lien/5.1x total in the first quarter, the average pro forma adjusted debt multiple of M&A deals backed by leveraged loans expanded to 4.6x first-lien/5.7x total during the three months through mid-June. This is in the upper half of a multi-year range. What drove the trend was not an increase of higher leveraged transactions – the share of deals with leverage of 6x or more stayed constant in the 44-45% range – but rather a decline in lower leveraged transactions.
While none of these cyclical trends are terribly shocking – save, perhaps, for how well the leveraged loan and CLO markets traversed the pandemic – it may be reassuring to see the well-worn themes continue.