September 30, 2021 - by Meredith Coffey. Considering that we’re still in a global pandemic, spec-grade credit statistics don’t look too bad. While that likely will continue into the near term, questions remain about the long-term credit outlook. We dissect the stats from various sources below.

Let’s begin by looking back. According to both Fitch and S&P/LCD, leveraged loan default rates are at multiyear lows. (Their methodologies differ, and thus so do their numbers, but the trends align.) According to LCD, the default rate in the S&P/LSTA leveraged loan index dropped to 0.47% in August, roughly one-tenth of where it was a year ago and the lowest level in nearly a decade. (Note that S&P/LCD excludes distressed debt exchanges from its default figures.)

Fitch sees similar trends, with institutional loan defaults falling from 4.5% a year ago to 1.2% today. (Fitch includes distressed debt exchanges and other non-bankruptcy restructurings, which together comprised 61% of TTM defaults.) Under Fitch’s headline numbers, some notable stats emerge. For instance, as the COW demonstrates, at 0.9%, the default rate for sponsored deals – including distressed exchanges – was lower than the rate suffered in the non-sponsored market (2.3%).

While the default statistics are encouraging, the recovery given default statistics are perhaps less heartening – if also unsurprising. According to LCD and S&P’s LossStats, while loan recovery on 2020 defaulters increased slightly from the year-earlier cohort, the trend generally is not our friend. The average discounted recovery for recent defaulters was 72.2% as compared to the 20-year average of 80.3%.  Why? Well, first, higher default rates correlate to lower recoveries, as both reflect economic conditions. But second, current loans generally have less debt cushion – 23% for the recent cohort vs. 39% in the prior 20 years. And third, covenant lite loan recoveries are coming in lower, averaging 63% over time.

Looking forward, where do we go? The near term is looking solid. LCD reports that public reporters in the S&P/LSTA Loan Index enjoyed EBITDA growth of 21% over the (admittedly depressed) same period last year. Also, in the last six months there have been 2.3 ratings upgrades for every downgrade in the Index. In a quarterly LCD survey, market participants – presumably also excluding distressed exchanges – expected loan default rates to sit at 0.98% in a year.

Fitch too has upgraded its outlook, revising its institutional loan default forecast to 1.5% for year-end 2022, down from 2.5-3.5% earlier. All told, this suggests a cumulative 2020-2022 default rate of about 7%, less than half the cumulative 15% default rate seen in the 2008-2010 financial crisis.

So that is all good. But the longer term might have its challenges. First, despite a bit of an improvement lately, the ratings mix in the S&P/LSTA Index is not as happy as it once was. While the share of loans rated B- and below declined 3.5 percentage points since peak pandemic, it still sits at 30.3% of the Index. This is up from 25% just before the pandemic and nearly twice the level (16%) seen in 2018.

And then there’s the documents. According to Covenant Review, the Credit Suisse Index has seen loans with looser documentation replace those with tighter documentation throughout 2021. CR scores documents from 1 (tightest) to 5 (loosest). August saw 65 loans enter (average score of 3.79) and 46 exit (average score of 3.29).  For the year to date, 494 loans entered the CS Index (3.71 average), while 457 exited (average score of 3.3). All told, the CS Index doc score has deteriorated from 3.33 to 3.47.

Perhaps like many markets, the loan market might see a bifurcated future. We may be set up to perform quite well in the near and medium term. But there may be cautionary signs – average ratings, doc scores – that might temper enthusiasm in the longer term.

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