August 13, 2020 - The cross currents of credit concerns on one hand and technicals on the other are pulling the loan market crosswise. We discuss the currents – and the resulting course – below.
The credit concerns should come as no surprise. In the wake of the global pandemic, the trailing 12-month leveraged loan default rate has climbed past 4% (by count, says S&P/LCD; by volume, says Fitch). While COVID-19 has slammed many industries, the pain is not uniform. Oil & Gas (31% default rate this month) and Retail (10% in May) continue to be hit the hardest. Excluding O&G, leveraged loan defaults sat at a better, though hardly encouraging, 2.99%. A global exogenous shock like the pandemic – and an unprecedented contraction in economic activity and corporate cash flows – mean that few foresee a change in the default trend anytime soon.
With a deteriorating credit environment, it’s little surprise banks pulled in their horns (and terms) in second quarter. The recently released Federal Reserve’s Senior Loan Officer Opinion Survey (“SLOO”) revealed that banks tightened metrics across the board for corporate borrowers. A few quick stats: 75% of large banks said they tightened standards for large and middle market corporate borrowers. 87% increased spreads. 78% increased risk premia. And 78% increased the use of interest rate floors. An interesting nuance here is that 41% of respondents increased use of interest rate floors “considerably”, the most stringent
response. While that may not be surprising in a rapidly falling interest rate environment, other tightening metrics were concentrated in the less stringent “tightened somewhat” category. Consider covenants: 66% of banks said they tightened covenants, but only 3% said they tightened them considerably. (We’ll return to the covenant theme later.) For additional SLOO stats, we recommend readers visit Refinitiv to see i) where loan terms stand relative to their 15-year average (hint: tighter) and ii) bank tightening trends over time.
While credit deterioration should be softening demand, technicals generally are pushing in the other direction. CLO formation has recovered to a degree no one would have forecast in April: issuance hit $9 billion in July. Meanwhile, loan mutual fund flows actually turned positive in early August. To be fair, loan formation – and hence supply – has picked up in recent weeks. LevFinInsights currently tracks $8 billion of loan formation (in market and in pipeline) net of all refinancing activity. This is up substantially from July ($1.9 billion) and June (-$3.6 billion). But flow is slowing for August recess and it has been short of (even modest) demand from the buyside.
How do credit concerns marry up with a modest technical imbalance – and what is the impact on pricing and structure? All-in spreads on B+/B rated TLBs contracted nearly 100 bps (to LIB+529) between May and July. (Of course, they remain well above the LIB+342 borrowers enjoyed in January.) Meanwhile, lenders regained their appreciation for LIBOR floors: According to S&P/LCD, 95% of new first lien institutional had floors, up from just 14% in January (See COW). Pricing is important, but docs are forever. (Well, they are forever if there is a default; they are ephemeral in a repricing wave.) On the doc side, Covenant Review offered a surprising, yet somehow also predictable, story. Loan documents improved materially as the market reopened (mostly for rescue financings) in April. Final documentation scores tightened from 3.66 in March to 2.91 in April (with lower scores representing more conservative deals). But fast forward to July, and the doc scores loosened back up to 3.49.