January 28, 2021 - Covid-19 was the mother of all stress tests for the leveraged loan market. Fortunately, as the GAO’s report on leveraged lending noted, both loans and CLOs came through in solidly, if not completely unscathed. But what lies ahead? In this missive, we update where credit went in 2020 and where it may be heading in 2021.
First, 2021 was rough – but not as rough as it could have been. As Covid-19 hit US shores and the economy was shuttered, rating agencies downgraded companies rapidly and increased default forecasts materially. Still, defaults were not as bad as anticipated last March. Fitch noted that the institutional loan default rate ended the year at 4.5%, a bit tighter than they had anticipated. Meanwhile, the S&P/LSTA Loan Index’s default rate ended December at 3.83%, more than double the 1.39% seen at year-end 2019, but still way short of estimates. As the COW demonstrates, default volume was nearly the same level seen in the Financial Crisis. However, today’s market is much larger, so the default rate was far lower than in 2009.
While defaults didn’t get anywhere near record levels, ratings did drop significantly. Excluding defaulted loans (which, per above, more than doubled), the share of B- loans in the Index increased from 19.3% at year-end 2019 to almost 24% in 2020; CCC/CC/C credits increased from 6.1% to 9.33% in the same period. And a number of companies that had financial maintenance covenants did return to amend them: LCD tracked 193 companies that sought covenant waivers, slightly higher than 186 in 2009. To be fair, with many institutional loans lacking maintenance covenants, most of 2020’s waivers addressed pro rata tranches. Still, even covenant lite institutional tranches can benefit from the guardrails of having maintenance covenants in an affiliated pro rata tranche.
So where is the market headed? Fitch notes that the default rate likely will be lower than expected; they lowered their 2021 institutional default forecast to 4.5% from the original 7-8%, noting that refinancings have pushed out the maturity profile materially. In the Credit Outlook Survey, meanwhile, IACPM members generally saw US default rates continuing to rise: 63% said North American corporate default rates would rise, while 18% saw them flat and the remainder saw them declining.
Still, folks certainly aren’t complacent about credit quality. (And handshakes; more on that later.) In LCD’s Year End Survey, 26% of respondents said they were most worried about credit quality, ahead of Covid-19 lockdowns (19%) and documentation/loopholes (15%). But those loopholes are worrisome too! In Refinitiv’s Year-End Survey, respondents wrote in that key concerns include a permanent change in protections in asset class, additional debt layering, super priority debt exchanges and more.
But is the crisis (nearly) all over? Maybe, maybe not. Refinitiv’s respondents said we’re likely through the worst, but there is potential for more deterioration due to Covid-19 and there may be elevated problems and/or residual effects for companies for years. Meanwhile, we could see a continued decline in Covid related businesses if behavioral changes stick.
Speaking of behavioral norms, handshakes maybe back. Maybe. 60% of respondents are not shaking hands until Fall 2021 – and 30% are never shaking hands! But they may return to handshaking (or elbowbumping) at an in-person event this year: 75% said their first in-person event would be Fall 2021. (On that final positive note, we’d add that the LSTA has soft-circled its Annual Conference – in person – for the first week in November. We hope to see, but maybe not touch, you there!)