November 14, 2019 - While some headlines might suggest otherwise, we know that markets ebb and flow. After all, that’s what makes them markets. Today we are doing a short pre-holiday check in on how that ebbing-and-flowing loan market is doing.

First, as has been discussed everywhere – including these pages – we have been in a “shift to quality” mode. This is demonstrated by a bifurcation by credit in the primary and secondary market and an appetite for safety and quality. And, perhaps unsurprisingly, this change is happening in advance of any changes in actual default rates. We deconstruct these trends below.

First, credit quality.  While default rates certainly are low, they are forecast to rise (albeit to still-moderate levels) in the coming years. To wit, Fitch’s trailing 12-month loan default rate sits at 1.7% but is expected to climb to 3% around year-end 2020. (However, Fitch also notes that nearly half of loans that default could have a greater than 90 cent recovery.)

Unsurprisingly, the loan market is evolving ahead of any potential defaults. First, consider year-to-date lending volumes. As demonstrated in a recent LCD Weekly Wrap, year-to-date lending volumes are down across the board.  LCD’s overall leveraged lending is down 23% year-over-year, LBO lending is off 22% and institutional volumes are down 32%. Refinitiv LPC concurs in its Leveraged Loan Monthly, noting that their leveraged lending is down 41% and institutional lending is off 53% for the year; in contrast, high yield issuance is up 35% year over year.

Moreover, there is a distinct appetite for quality these days. First, secondary loan performance bifurcates on rating. As of mid-November, BB loans in the S&P/LSTA Index are priced at an average of 99.01, while single-Bs sit at 96.06.  Contrast this nearly 300 bps differential to the 120 bps gap between BB and B names in early March (see COW). Meanwhile, in the primary, LCD notes that i) BB spreads are now 222 bps narrower than B rated loan spreads and ii) the “private credit market hails secular change amid BSL bifurcation”. In other words, as CLOs lose their appetite for new single-B rated loans, more may be emerging in the direct lending space. 

The BSL preference for better terms shows up in Covenant Review’s Documentation Flexes as well. Notably, the original average Composite Documentation Score of deals launched in October was 3.77 (in a range of 1 (tightest) to 5 (loosest)). However, lenders pushed back a record amount. Final (post flex) Document Scores averaged 3.45, a record 0.35 “turns” tighter – and at the more conservative end of the recent range. So what do we take away from our pre-holiday market check-in? While some commentators see every fluctuation in the market as a sign that The End is Nigh, we see these ebbs and flows as characteristics of a market that self corrects.