“Fed chair tempers fears over corporate debt meltdown” read a headline in the Financial Times this week. On the face of it, it was a reassuring message. But it’s interesting to ponder how many readers’ eyes are likely to have been first drawn to the phrase “corporate debt meltdown” rather than “tempers fears”.
Leveraged loan experts at an event run by S&P Global in London this week were keen to point out that the market is thriving, with record volumes in 2017 driven by a highly favourable credit environment and a still-strong market last year. But we all know that’s not the whole story, and lurking behind the dynamism are the risks. A poll of the audience suggested leverage to be the biggest concern, but the prevalence of covenant-lite and rising interest rates are worries too.
PDI jotted down some key points to share with our readers:
Sentiment is cautious: is the market self-correcting?
New issuance of leveraged loans is down by 20 percent for the year-to-date compared with last year in Europe and by 5 percent in the US. This barely qualifies as a slump, since 2017 and the first three quarters of 2018 saw unprecedented strength in the leveraged loan market globally. But if it does indicate the brakes being dabbed, this is unlikely to be a bad thing for a market that many have perceived to be in danger of overheating.
Diversification is under threat
Although the volume of issuance remains reasonably resilient, the nature of it suggests investors will struggle to achieve a diverse portfolio. The market is heavily skewed towards larger deals and add-on acquisitions, while cross-border volumes are down.
Furthermore, demand is struggling to be met by supply. This is the opposite to last year, when the supply/demand equation was the other way round.
Leverage multiples continue to be a worry
In Europe, the average leverage ratio at the end of March was similar to last year’s average at around 5.5x. However, the share of deals with leverage of 6.0x or greater has risen year by year, reaching a peak of 41 percent of the total during the first quarter of 2019 (compared with 31 percent in 2018 and 23 percent in 2017). Nevertheless, purchase price multiples fell to around 9.5x in the first quarter compared with more than 10.0x last year – helping to take a little of the pressure off.
A thumbs-up for debt coverage
The ability to service the debt is good. Around the time of the global financial crisis, interest coverage was at an all-time low of 2.5x. This meant companies had virtually no room for error: as soon as they encountered trouble, they were struggling to cope with their debt burden. In recent years, coverage has been consistently around the 4.0x mark. Moreover, the “maturity wall” is long-dated, with more than three-quarters of maturities five or more years away.
Not defaults, but downgrades
There has been a notable decrease in credit quality in the leveraged loan market. In a predominantly covenant-lite environment, what we’re likely to see more of is not defaults but downgrades. Collateralised loan obligations in particular – as the largest investor base in the leveraged loan market – need to prepare for the consequences of a weak economy and consequent downgrades, as they have a limit on the amount of low-rated paper they are allowed to hold.
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