Leveraged loan defaults rise but cash-flow coverage should avert US credit crash…for now

Rachelle Kakouris, S&P Global Market Intelligence

The second quarter of this year saw two potentially worrying trends in US corporate credit: the number of public filers carrying debt of more than 7x going into Q3 had risen to 35 per cent (compared to 14 per cent in Q4 2018), while the percentage of leveraged loan defaults rose sharply from 2 per cent at the start of the year to north of 4 per cent, by March.

Those numbers, recently conveyed by S&P Global Market Intelligence and based on the S&P/LSTA Loan Index, were symptomatic of the early stages of the lockdown. It is perhaps unsurprising to find that Q2 also saw a 23 per cent decline in EBITDA among US companies with leveraged loans. That exceeds the peak decline of 18 per cent recorded in Q1 2009 following the GFC.

As Rachelle Kakouris, Director, Leveraged Commentary & Data at S&P Global Market Intelligence remarks: “You can’t have a 23 per cent decline in EBITDA, and leverage soaring, and not expect to see elevated default rates going forward.”

Although this is only a small sample size of the wider leveraged loan marketplace, it is perhaps a sign that some US companies are beginning to bear the weight of debt on their balance sheets like pack mules. Some might survive and prosper, as happened following the two previous recessions in ’01 and ’08; plenty might not.

So the question is: Do rising loan defaults in the US suggest the storm clouds of a corporate credit crash looming on the horizon, or merely a temporary downpour?

At first glance, one might argue the case for the former. Declining EBITDA and purchase price multiples in sectors such as energy (80 per cent drop in EBITDA growth) and aviation, do not make for pretty reading in respect to the health of corporate America. But a deeper dive into the statistics would suggest that actually, the latter is a more likely outcome.

One of the key metrics to support this is if one looks at average cash-flow coverage. This remained relatively stable through the first two quarters of 2020, at around 2.7x. What this means is that leveraged corporations have a more stable cash buffer to absorb the turbulence of Covid-related volatility.

If this cash-flow coverage multiple had also fallen sharply in Q2, it would have seriously signalled the potential for a credit crunch, magnifying the effects of higher default rates and leverage levels.

Through Q2 this year, less than 30 per cent of leveraged loan filers had cash-flow coverage of less than 1.5x.

In Q4 2008, that number was 44 per cent, so nearly half of loan issuers were skating on thin ice.

“The percentage of companies with cash-flow coverage of less than 1.5x is much lower now than it was back in 2008,” says Kakouris, adding that investors first start to pay close attention when the coverage figure falls to 3x.

Even though US companies are taking on greater leverage, they are in a better position to service that debt than they were at the outset of the GFC.

“It doesn’t mean they won’t default,” continues Kakouris, “it just means they have a longer runway before getting to a default stage. Depending on market conditions and the cost of the debt, it may not impact overall default volumes during this cycle but it may soften the blow in terms of peak defaults.” In other words, be supportive of a smoother rather than spiky default profile.

This does not factor in the impact of Covid-19 on Q3’s loan performance, and when asked if she expects the default rate to have risen even further, Kakouris replies:

“It looks like buyside managers are expecting a peak default rate of just under 7 per cent so that would definitely yield a higher volume of loan defaults than we saw during the ’08 financial crash.”

According to Kakouris, US companies have been going to the banks in record numbers. Approximately 162 companies entered into 126 leveraged loan transactions in the first eight months of 2020, compared to 154 in all of 2008. And of those 162 companies, 152 of them went to the banks at the start of April.

“The key factor, over the short term, will be access to funding and the willingness of banks to amend loan terms. That will determine the staying power, or the ability, for both public and private companies to get through this period and come out the other side,” she says.

Even though cash-flow coverage, and interest rate coverage, remains stable for now, affording US corporates time to get through the economic headwinds caused by the global lockdown, one can only substitute earnings for debt for a certain amount of time.

Even with a 7 per cent spike in default rates in Q3, this is still some way off the peak defaults recorded in 2008, which reached 10.8 per cent. But as Kakouris is quick to point out:

“While the market isn’t expecting that level of defaults this time around, it is worth bearing in mind that the leveraged loan market has more than doubled in size since the last financial crash. That has its own implications in terms of liquidity and being able to keep these companies funded.

“Also, you don’t need that 10.8 per cent default peak to repeat, in order to get the same volume of defaulted loans, if the market has doubled in size. To get the same amount of defaulted loans this time around, we have calculated that it would only require a peak default rate of just 5 per cent.”

This reinforces the earlier point as to why cash-flow coverage is so important in this current environment.

Most businesses that are being affected today by the pandemic are, in a very broad sense, perfectly sound and well run; especially those with PE sponsors. Some firms have been hit hard and filed for Chapter 11 bankruptcy such as Neiman Marcus and J. Crew, according to a separate S&P Global Market Intelligence research note published this summer on the link between PPMs and distressed debt.

As PPMs fall in Covid-vulnerable sectors, this could present good opportunities not only for PE sponsors to snaffle up companies at cheaper prices, before they fall into distressed territory, but also for the credit arms of big global PE groups, who decide to wait, before going in at a lower point of the capital structure to service the debt and equitize it as part of a restructure.    

Either way, as S&P Global’s research suggests, both PPMs and loans moved into an extended upward trajectory immediately following both the ’01 and ’08 recessions; could history repeat itself in 2020/21?

No doubt US PE sponsors will be watching the markets closely to find attractive entry points, as they bid to put a mountain of dry powder to work. As is always the case in financial markets, timing is critical.

For now, it would appear that the US corporate credit market is not stood on the precipice of collapse. Funding costs are still favourable, and the next major debt maturity wall, the majority of which is made up of leveraged loans, doesn’t hit until 2024.

“Most defaults do of course happen before maturity but at the moment, there is an interest and cash-flow coverage buffer that just wasn’t there during the last crisis. For as long as companies have liquidity and the funding markets are there, and they don’t leverage themselves to the hilt, then I would say it is an encouraging sign. I’d be far more worried if cash-flow coverage was lower.

“We are moving into a default cycle, but in terms of a mass implosion caused by leveraged loan defaults, the data is not yet supporting this scenario,” Kakouris concludes.         

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