Leveraged loan warning signs

Speaker A: There are going to be companies that are closed out of the traditional new issue markets and will have to look to more imaginative ways to manage their balance sheets.

Speaker B: Hello, and welcome to Invisible Capital, a podcast on the private markets. I'm Bren Jones, Senior News Manager for lcd, and I'm excited to welcome our listeners to season seven of the podcast. Podcast. We'll be doing something a little different this season with timely episodes published on a less regular schedule. So make sure you subscribe in order to receive our analysis and insights on a wide variety of topics within the private markets. With today's discussion focusing on leveraged finance and distressed credits. Quickly, a bit about lcd. LCD stands for leveraged commentary and data. And last June, we were thrilled to join forces with Pitchbook when Morningstar acquired us from S and P Global. LCD has been an industry leader in tracking and analyzing the leveraged finance markets for more than 20 years. We will reference, on occasion, the Morningstar LSTA leveraged loan indices and our wealth of research data as we attempt to make some sense of where we are and where we may be headed. Joining me in the virtual studio today are, uh, my LCD colleagues, Taryn Wade and Rachelle Kakouris. Taryn Wade is LCD's head of credit research in Europe. Taryn, welcome.

Speaker C: Hi, Bren. Thanks for having me.

Speaker B: Of course. And Rachelle Kukouris is a research director for us in the U.S. welcome, Rachelle.

Speaker A: Thank you, Bren. Great to be here.

Speaker B: Rachelle, we're going to start with you. Let's, uh, discuss the U.S. markets. Uh, despite a leveraged loan default rate that is holding below 1%, there are some ominous signs. The value of loans maturing over the next several years has increased. It is generally becoming more expensive to borrow. And I noticed quite a few recent additions to your restructuring watch list. Can you help break it down for us?

Speaker A: Yeah, I think you're right there. The low M default rate really is masking what has been, um, a rising undercurrent of troubled companies within our loan index. Um, to just put this into context, at the end of last year, we had over 100 billion of leveraged loans that were priced in at distressed levels, which we draw the line in the sand there at $0.80 on the dollar or below. So this is some eight times higher than it was earlier, uh, in the year. It's a lagging indicator. So we are starting to see some signs bubbling up that there could be further trouble down the road.

Speaker B: And when we're looking at all of those distressed credits, do you see any patterns on your Watch list. Uh, are there any sectors that stand out or uh, situations ongoing right now that merit quite uh, a bit of attention?

Speaker A: Um, certainly Software. We've seen a particular jump in distress from that sector these past few months. We've obviously seen frequent headlines around equity performance but its dominance isn't just in the stock market. Software has an outsized influence on leverage loans as well. So any stress or underperformance will in turn have and outsized impact on the broader loan index. Um, we currently see around 9% of all software loans marked at distressed levels and that's up from around 3% at the halfway mark of last year. But in just being such a large sector size that actually translates to 17% of all distressed loans that emanate from this one particular sector. Um, one pressing situation that we're watching for in terms of index defaults is Avaya. Um, this company is a, ah, digital communications provider and they disclosed late last year that they had held discussions with investors that could potentially see a second trip to bankruptcy court for the company. And this is a long standing loan issuer with three um, index loans that could potentially default. So there's broad exposure to the name among the loan investor base. Um, healthcare too, healthcare providers. We're seeing some fast moving situations coming through the pipeline. Air methods which is an um, air medical transport company that was recently hit with a three notch downgrade by Moody's to C AA3. And the pressure there, um, is largely stemming from the no surprises act in terms of medical billing, but just generally the sector is experiencing a lot of stress. But these two sectors alone, software and medical providers currently make up more than a third of all loans currently at distressed levels. And you mentioned our restructuring watch list, so thank you for that. I mean I think the pattern that we're seeing is actually just more entries, um, certainly more fast moving situations, but more entries. In mid 2022 we had somewhere in the region of 100 companies on this watch list and that jumped to 160 by the end of the 2022. So a 50% increase in the space of six months in terms of companies meeting our criteria as a potential restructuring candidate.

Speaker B: Yeah, your watch list is a wonderful resource uh, for subscribers. And can you just tell me what does it take to make it onto your watch list? What does a company have to do to uh, leap onto that spreadsheet?

Speaker A: Uh, yeah, it's a very good question. So we're trying to track imminent situations but also potential restructuring situations within the next 12 to 18 months. So if there's Been a, um, missed interest payment. If a company has warned of Chapter 11 or issued a going concern warning, checked a financial covenant, hired advisors. If a rating agency has deemed a, uh, company's capital structure as untenable or unsustainable, um, if they've launched a distressed exchange, these are the kind of things that are going to get a company on the watch list.

Speaker B: You mentioned tech and healthcare. I'll note that, um, our reporter Jack Hirsch has taken a look at the Morning Star High Yield Bond index, um, which shows that there's quite a high percentage of healthcare, uh, credits that are also in distress. So that's certainly a sector to watch. Um, can we talk a bit about the maturity wall? Um, oftentimes you see charts that show that, um, the debt to be repaid is just being kicked down the road. So we're all familiar with that sort of story. Uh, an interesting bit of data that uh, our research team is on Earth, both in US and in Europe, is that it seems as though there's more debt that needs to be repaid in the next few years than has been the case in the past.

Speaker A: Yeah, and I think, you know, the headlines have long been about the can kicking over the last decade, obviously we've had ready financial conditions and it's been a boon for uh, companies to raise cheap debt. We're no longer in that environment. And while companies certainly made good use of, um, favorable refinancing conditions, particularly in 2021, I think that was the third most active year for refinancings in leveraged loans. When we look more closely, while only 20% of the 3 trillion combined of uh, bonds and loans are coming due in the next few years, thanks to the post pandemic refinancing wave that we saw in absolute terms. And this is focusing on loans here. There's 280 billion of loans that are coming due in the next few years and 82 billion in the next couple of years. So in absolute terms, this is more than we've ever had in any other time on record. And if you break that down further, some 45% of that 280 billion that is coming due in the next three years are from companies rated B or lower. And for the debt coming due in the next two years, that jumps to 57% that will be coming due from companies rated B minus or lower. So not only has the quality of leveraged loans deteriorated in terms of ratings quality, but we in actual amount outstandings have more coming due in the nearer term than we've ever had so we're suddenly going into an environment now where the companies that needs debt refinancing the most are going to find they're running into expensive conditions if they can refinance at all.

Speaker B: Right. So the riskiest companies are those that are going to need to go back to the. Well, yeah, yeah, it seems like, uh, you know, 2017 was a huge year for leveraged loans. So I imagine a lot of those maturities are coming due in the next few years. Similarly, 2021 was obviously an enormous year too. So, uh, we'll have another surge a few years later. So, Richelle, can you tell us a little bit about the dynamics of the CLO market and how some of the sort of technical aspects of that market may affect this broader picture of leveraged loans, distressed and uh, refinancing needs?

Speaker A: Certainly. Well, we know that around 40% of CLOs are going to hit their reinvestment periods in 2023. So there's going to be, um, a known impact on liquidity in leveraged loans, just in terms of, um, the ease at which a CLO manager can move in and out of positions. Um, and we also know that the amount of new issue supply in CLOs will be less than what we saw last year. But nevertheless, there's still, um, a fair amount of dry powder to be put to work. But I think what we're going to see more of in 2023 is that differentiation in credit quality. So any rally that we've been seeing has often been used as an opportunity by managers to trade up from, um, triple C rated debt. So I don't think that this is really going to be particularly helpful for companies in the lower end of the credit spectrum.

Speaker B: Do you make anything of the secondary market gains so far this year, both in the US and in Europe? Uh, every single day has been a positive day for secondary returns in the loan market. Does that ease any potential pain or is it, um, not particularly relevant? Too, uh, early to tell?

Speaker A: I think it's probably too early to tell. I mean, the market is now hopeful for a better outcome than where we were towards the end of last year. So we've seen a persistent rally in leverage loans even during periods of weakness. We're even starting to see inflows for the first time, um, at least from ETFs. So we've had relentless outflows from retail accounts in leveraged loans. And, uh, economic prospects are starting to improve a little bit, at least in terms of sentiment. So the Fed has signaled potentially a 25 basis point hike Next time around. Inflation concerns are easing. We're seeing the base case now is more for a mild recession. So still a bit too early to tell, but we're hopeful for less volatility, I think in 2023.

Speaker B: Let's hope. Now let's shift to Europe for a second. Uh, Taryn, Um, it seems like the story is actually similar in Europe. Um, we have a parallel chart in our research decks showing that the maturity wall over the next few years in Europe is a little higher than it had been, um, in years prior. What are the implications? What are you seeing over there in Europe?

Speaker C: Yeah, that's right. I mean, we recently published some research looking at the maturity wall. Like you point out, um, it doesn't actually peak until 2028, but there is a big spike in 2026. And this is using the Morningstar European Leverage Loan Index, um, looking at the outstandings. And if you look at the next three years, um, similar to what Rochelle was saying, you know, we are seeing a huge increase in the amount that is coming due on an absolute basis. So for example, in the next three years, about 64 billion euros comes due, um, and that's up from about 35 billion at year end 2021. So it's nearly double in a year. That's a three year, um, maturity cliff. Um, and it's over double what it was at the year end 2020, which was, ah, 27 billion euros. So there's also a lot of big near term maturities, some really big loans that are coming due in 2024, uh, from Ineos Group, um, a couple of other ones. Uh, so we, you know, we published a list of those in this research that we put out. And I think what's interesting is the fact that last year in Europe, one of the biggest trends was the real drop in loan issuance. I think that was much more dramatic in Europe than it was in the us. Uh, we did not see an uptick in refinancings towards the end of the year. In fact, if you look at total loan volume, it was down 55% in 2022. Um, and institutional volume, which are loans that are syndicated to institutional investors. So this doesn't include the bank facilities. That was down 69%. And of this only, um, 23% was for refinancings, which is a very low number. So we just did not see that many companies go out to refinance in 2022. Uh, we saw a lot of M and A activity at the beginning of the year. And then the market was really just not very active. Um, so there is a lot of refinancing that needs to be done and I think the news is actually pretty good so far. In January we've seen in the last week, um, there were seven deals launched in Europe that were for refinancings, extensions or amendments. So that's a really positive story so far this year that um, we are seeing refinancings coming to market.

Speaker B: Taryn, both you and Rachelle did surveys at the end of last year to get a lot of market sentiment on the year ahead. Um, looking back at those surveys, uh, does anything stand out or uh, has anything shifted since the time of those surveys? Uh, Taran, we can start with you.

Speaker C: In Europe, I think that what we're seeing so far this year things look a lot more optimistic than they did. When we looked at the survey, market participants showed a lot more pessimism. Um, the majority, 54% said that the worst is yet to come regarding volatility and leverage markets. And the same amount, same number of people, 54% said that the European uh, leverage loan index, ah we refer to it as the le, has not hit its lows of the cycle. That was quite interesting because um, we did have a really difficult year in terms of secondary market returns. Looking at the le, uh, it was the worst year of performance since the global financial crisis back in 2008. Uh, we had a 12 month loss of 3.6%. Now when you compare that to 2008 it actually doesn't look like that big of a loss.

Speaker B: Right.

Speaker C: Back in 2008 the index lost 27.59%. So that was a very big loss. Uh, to give um, our listeners a bit of context, the average return for the LE over the past 10 years has been 3.69%. Um, and at the end of 2021 it was 4.81%. So that was a really good year on 2021. So this loss does look quite deep. Um, but we also to be fair

Speaker B: to loans, uh, it was relatively not as bad as other asset classes where losses were even much greater. But, but, but for loans obviously it was a, it was an off year. And uh, and so far things uh, are actually surprise, have been slightly surprising to the upside.

Speaker C: Yeah, completely. And actually the fourth quarter of 2022 we saw, we saw an improvement in the alley. So you of the return was actually 3.51%. So um, we saw a late summer rally, there was another dip, we had a lot of clo issuance. I think, I think people in Europe were quite surprised by the steadiness of CLO issuance in the second half of the year. So that really you knew they were looking for deals and secondary markets put into these new transactions. Um, they were also looking for value as loan prices got hit. Um, they would, they would look for um, ah, deals in the market. So the fourth quarter. And then so far this year we've seen um, the LE is up 2.32% so far in January as of Friday the 20th. Um, so yeah, so I think things do look better compared to the survey results. Um, but I think that the turnaround and sentiment has been very quick. Um, and there's still a lot of caution in the market. Um, the feeling like as Rochelle said, that the problems the market faced are still there, it's still early days. Um, potentially inflation may look like it has peaked, but we don't really know. Um, it is still probably too soon to tell.

Speaker B: Mhm. Yeah. The leverage loan default rate I believe is below 1% both in Europe and the US and I noticed on your surveys with the median estimate was 2.5% to 3%. So we're not there yet. We haven't nudged, actually approached 1% even yet. Rochelle, looking at the U.S. can you explain a bit how a, the default rate is a trailing indicator and what we should look for if we're trying to figure out, you know, trying to read into the future a little bit?

Speaker A: Yeah, well I think you know, the credit landscape is still firmly on um, the radar and so while the default rate might be a lagging indicator, you know we would look to distress volumes, we would look to the pace of ratings downgrades, we would look to um, you know, just the credit quality of the index and upcoming maturities. And you know, we've seen that B minus rated loans are now the largest share of the index for the first time. And even just going back to the survey, while some of the sentiment has changed in terms of performance and maybe even demand for the product, you know, the underlying problems or landscape remains relatively unchanged. Um, and I was actually quite pleasantly surprised by where the default predictions came in. Most respondents came in expecting a uh, default rate at the end of 2023 to be around 2.5 to 3%. And some of the predictions out there on Wall street varied massively. We saw some banks come in with loan default predictions of 9%, some even as high as 11, um, some coming in more the middle of the range. It's. And then um, some I think including a number of top tier investment banks coming in at around 3% which is closer to where our respondents were. But just to give a sense of what it would take to get to these numbers. So for leveraged loans, to see a default rate of say where we peaked in 2008 at 10.8%, that would take roughly 145 billion of leveraged loan defaults to happen in the next year. And even though we do have um, a pressing maturity rule of lower rated borrowers in the next couple of years, I don't really see where this number could come from to get to a near 11% default rate. So I think I'm more comfortable around the 2 to 3% level which would stop, start to get as close to historical averages but not into a full blown Armageddon default cycle.

Speaker B: Right, yeah. And Taryn, I noticed that uh, there was an article published by Leonie Dackom on the European Leveraged Loan Index on how the percentage of credits that are lower rated has increased. Um, so it does seem like the credit quality of loans is something that you sort of to watch.

Speaker C: Yeah, we published some research that showed that uh, the B minus credit percentage of the LE was 20.4% in December 2022. And that was if you look at pre pandemic levels of single uh, B Credits, they were 12.7% in January 2020 on the eve of the pandemic. Um, and this share has steadily increased. This isn't, this is sort of a longer term trend. Um, it steadily increased since the global financial crisis low which was 4.7% in October 2017. So we have seen a similar trend. Yeah, as what, what is happening in the U.S. you know we default rates are very low in Europe. If you look at our LE, um, they were only 0.42% for 2022 year end, um, on a rolling 12 month basis. And like in the US you know we have, our participants in the survey projected this rise in default rates to 2.75% on average. Again, you know it is, it's difficult to see, you know, getting to that point. Um, it does make sense from the perspective of we are expecting defaults to rise. We um, just haven't seen, seen that many in Europe. And I think a lot of people here say it's because of the covenant light nature of the market. Um, we've gone to essentially a covenant light, which means there are no financial maintenance covenants on the loans in Europe. Uh, that's been a trend that's over since the global financial crisis. We've seen covenant light loans grow so that could be one reason that we're not seeing it. I think. You know, there's also the expectation that we may see defaults in the private credit market, the direct lending market. That market continues to take share from the syndicated loans market in Europe. Uh, we saw only last week KKR did a direct lending club of £800 million. Uh, it was a unitrange for the acquisition of April, which is a French insurance services firm. So we're seeing really huge deals coming from the direct lending market. So I think there is an expectation we will see defaults in that market. And so much more opaque market. Those deals are not included in our index. Um, so that is definitely one area that we'll be watching in 2023.

Speaker B: Yeah, indeed. The private credit market has taken a big chunk out of the institutional leveraged loan market here in the U.S. i think we had some data showing what, like 58, uh, LBOs financed by private credit in the fourth quarter in the U.S. as opposed to one, uh, by the broadly syndicated loan market. So that's a big shift, a big trend to track. Sort of. On that note, uh, sort of a last question I'll pose to each of you. What are you most interested in tracking in the weeks ahead? Uh, specifically, uh, Taryn, why don't we start with you and I'll just use this time as you formulate an answer to that question, to plug. Uh, LCD will be doing a webinar, uh, there'll be a pitch book, LCD webinar on the private credit and leveraged loan markets. Um, that will be, uh, held on January 24th. Uh, we're recording this on January 23rd. You will be getting this podcast afterwards. So we will make sure that in the links, um, of this podcast episode, we will have a link to that webinar. Um, there's tons of extremely valuable market information is shared in these webinars. So we encourage everybody to check out the show links. Okay. So Taryn, uh, what, uh, what will you be tracking in the weeks and months ahead?

Speaker C: Well, I think the point I made about direct lending, I think that's something that we are tracking more and more at lcd. You know, we want to be able to compare the syndicated lending market and um, high yield market and the direct lending market. So we are working on data around that. Um, and I think just, you know, is issuance going to be coming back so that 2023 looks like a quote unquote, more normal market? You know, will we be seeing refinancings? Will we see a return of M and A I think a lot of people have told us that private equity will be focusing more on their existing portfolios and less on going out and doing new transactions. So will that be the case? What will the structure of those deals look like? Our survey participants said that leverage is expected to decrease and equity contributions to increase. Will that transpire? And again, you know, what is the credit quality? Will we continue to see lots of B minus credits? Um, but yeah, I think it's going to be a very interesting year considering how challenging 2022 was.

Speaker B: Yeah. And Rachelle, turning to you, what are you looking forward to tracking most? What are you most interested in over the next few weeks?

Speaker A: Well, I think the cost at which companies are, um, having to pay, how much they're having to pay to raise debts or refinance in the new issue market. Even just looking at double B credits and how the yield required by investors to buy this debt in the primary market has more than doubled since the beginning of last year. It's huge. So there are going to be companies that are closed out of the traditional new issue markets and will have to look to more imaginative ways to manage their balance sheet. So I think looking also at, um, single name situations, there are going to be outliers that are going to either be shut out from the traditional funding markets or have to pay prohibitive funding costs. So I think just looking at credit situations coming down the pipe, um, we've seen obviously a lot of fast moving situations coming through. So that's something that I will be monitoring as well. And of interest to me and, and also at the sector level, kind of an expectation that even if we don't go into a full blown recession, there's going to be rolling default waves, potentially, be it software, um, and other sectors potentially impacted by recent inflationary costs and recessionary pressures. So yes, for me, I'm more interested to see how this plays out on the credit side. Yep.

Speaker B: Um, well, thank you very much, Rachelle and Taryn for your awesome analysis and for all you listeners, thank you for tuning in to this podcast of Invisible Capital for show notes and links to what we discussed today, including that Pitchbook LCD webinar I mentioned on the private credit and leveraged loan markets. Visit pitchbook.com podcast for guest inquiries. Contact us at podcast at pitchbook. Com. And for LCD's definitive primer on the leveraged loan markets, you can check out leveragedloan. Com. I'm Brent Jones. Thank you again for listening.