October 11, 2018 - Third quarter was spotless, S&P/LCD wrote on October 1st. With nary a default in the S&P/LSTA Leveraged Loan Index (LLI), the default rate slid to 1.81% in September, a 10-month low. But that wasn’t prophesied to last long – and it didn’t. This week, it’s all about Sears. First, Sears hired an advisory firm, then it was reported to have missed vendor payments, then it was reported to be in DIP discussions in the context of a liquidation and, finally, folks are expecting a bankruptcy filing by Monday.
But despite October’s inauspicious start, the near-term outlook remains benign. Fitch anticipated Sears’ default and, even so, sees their loan default rate sliding from approximately 2.2% today to 2% at year-end 2018 and 1.5% in 2019. Fitch sees an improvement in retail (Sears notwithstanding) and energy, minimal near-term maturities and favorable market access. Meanwhile, Fitch’s “Top Loans of Concern” list has fallen 26% to $20 billion since last December.
S&P/LCD echoes that general lack of pressure. When looking at public filers (approximately $200 billion of loans) in the LLI, LCD notes that just 5% of these companies have interest coverage ratios of less than 1.5x, a level that can indicate vulnerability. Meanwhile, overall interest coverage ratios of public filers are sitting in the 4.73x context, around historical highs. Moreover, interest coverage ratios remain this high even as rising LIBOR has driven all-in loan interest rates up more than 60 bps since year-end 2018.
But still, we shouldn’t be complacent. LCD notes that while default rates have been trending down, the downgrade/upgrade ratio (currently 1.78:1) has been increasing since the beginning of the year. Meanwhile, Fitch counsels caution by reminding us that lower default rates should be considered in the context of where we are in the credit cycle; typical late stage markers include improving profitability, open access to credit markets and, notably, looser credit terms.
And, indeed, third quarter suggests loan documents are loosening again, Covenant Review reported. First, after declining in second quarter, companies’ ability to add incremental debt increased in third quarter (but remained more lender friendly than in first quarter). Second, on the EBITDA adjustment side, the share of loans that allow uncapped EBITDA adjustments climbed slightly, but still remains well below 1Q18 levels.