A buoyant loans market, but clouds are on the horizon

Plentiful liquidity and a low default rate are generating optimism for leveraged loans, but aggressive leverage may yet cause concern.

Everything’s seemingly coming up roses for leveraged loans, given the near-record low level of default rates the market saw in 2021.

Credit for that goes to a market awash in liquidity, which allowed companies to refinance and push out near-term maturities, and double-digit earnings gains, which pushed cashflow and interest coverage to a new record high.

Indeed, the S&P/LSTA Leveraged Loan Index, which measures the default rate, closed out the year at 0.29 percent, a mere 14 basis points above its all-time low, and far below the historical average of 2.82 percent. Moreover, just five issuers with $3.4 billion of index loans filed for bankruptcy or missed interest payments last year, a fraction of the 50 issuers that defaulted on $45.7 billion of index loans in 2020.

But another record-setting trend last year reported by S&P’s Leveraged Commentary & Data –  that a whopping 44 percent (or $147 billion) of the unprecedented $331 billion in M&A-related loan issuance went to companies rated B-minus by at least one rating agency – should raise a soupcon of concern. By comparison, B-minus rated loans accounted for 31 percent of the total in 2019, and just 16 percent in 2007, right before the financial crisis.

“We’re seeing more aggressively structured deals,” says Marina Lukatsky, senior director, LCD. On average, the debt/EBITDA ratio stood at 5.6x last year, tying a record high that was first set in 2018, according to the LCD report.

Moreover, buyouts and acquisitions by private-equity backed borrowers carried roughly 1.5 extra turns of leverage – or 6x – relative to the 4.4x carried by non-sponsored borrowers. Lukatsky notes that 19 percent of the deals were levered at more than 6x, not exactly an overriding cause for confidence.

“Market stress will be concentrated in specific sectors or areas within the markets,” Lukatsky says, adding that technology, the biggest sector within the loan market, typically has a higher multiple than the rest of the market.

“The overall markets are priced to perfection,” Blue Owl co-founder and senior managing director Craig Packer said in his outlook for direct lending in 2022. And respondents to a fourth-quarter survey of leveraged loan market participants by LCD found that 28 percent think a significant decline in secondary loan prices could happen in the next six to 12 months.

“We feel we have an overextended market and believe there are many similarities between this market and the market we saw in 2007,” says David Conrod, chief executive officer of FocusPoint Private Capital, a private fund placement business.

Perhaps it’s time to prepare for the bloom coming off the rose.

Write to the author at robin.b@peimedia.com