By Yun Li and Jonathan Schwarzberg
NEW YORK (LPC) - Overwhelming demand for floating-rate leveraged loans has eroded credit quality and will lead to more defaults and lower recovery rates in an economic downturn, according to ratings agency Moody’s.
Leveraged loans have become the go-to instrument of choice to finance private equity buyouts, due to their flexibility and lack of repayment penalties, but the ratings agency is warning that investors are sacrificing credit protection as more lower-rated companies tap the markets.
Average first-lien term loan recoveries are expected to tumble to 61 percent from an average of 77 percent historically and average recoveries for second-lien loans will fall to 14 percent from 43 percent historically, bringing heavier losses for investors, according to Moody’s.
The prevalence of senior loan-only structures, which lack a cushion of junior debt, is expected to be a major factor in lower recovery rates and could produce an extended default cycle, according to the ratings agency.
"The result is more defaults than the last downturn as well as lower recoveries, undercutting a foundational premise for investing in loans," said Christina Padgett, a senior vice president at Moody’s.
The move to bond-style covenant-lite structures with little investor protection has further boosted the appeal of loans. More than 70 percent of syndicated US leveraged loans are now covenant-lite, compared with 25 percent during 2006-2007, according to Thomson Reuters LPC.
“Loans are becoming more bond-like with these convergence trends causing investors to lose more control over debt terms and credit protections,” Moody’s said in a note published August 16.
Around $891 billion of US leveraged loans have been issued as of August 14, which is already 6.9 percent higher than last year’s record of $833.7 billion in the same period. High-yield bond issuance, on the other hand, has slumped 28 percent to $116 billion compared to $161 billion in the same period in 2017.
“Wall Street has met the demand with increased supply of loans versus high yield bonds, but we are concerned about the erosion of traditional lender protection,” said Brian Juliano, head of US bank loans at PGIM Fixed Income. “I do think that some of the covenants are merging towards traditional high yield bond covenants.”
The loan market added $73.5 billion in July as the US summer doldrums approached and business has been unseasonably brisk in the August holiday period.
This week specialty materials company Boyd Corp wrapped up a $1.3 billion first-lien loan and a $315 million second-lien loan to finance its acquisition by Goldman Sachs (NYSE:GS) Merchant Banking and last week healthcare data analytics company Verscend Technologies lined up a $3.165 billion term loan to finance its purchase of analytics provider Cotiviti Holdings.
LOWER RATED
Loans are traditionally rated higher than bonds due to seniority in the capital structure, but lower quality loans are rising. CCC-rated loans now total 5.4 percent of leveraged loans as opposed to 3.5 percent just before the credit crisis in 2008, according to an August 15 report from UBS.
B- rated loan volume totaled $39.1 billion through August 16, up 90.7 percent over the same period in 2017 when volume totaled $20.5 billion, according to Thomson Reuters LPC data, and CCC rated loan volume added up to $3.2 billion over the same time period, up 23.1 percent over $2.6 billion in 2017.
The share of first-time debt issuers rated B3 reached a record 43 percent in the first half of 2018, and about 64 percent of US speculative-grade companies have a corporate family rating of B2 or lower, according to Moody’s.
Ethics and compliance management services provider NAVEX Global wrapped up pricing last week on a $639 million covenant-lite credit facility to support an investment by BC Partners. Although the $154 million second-lien portion of the deal is rated only CCC, the issuer still managed to drop pricing to 700 over Libor from guidance in the 750bp-775bp over Libor range.
“Part of the reason for lower ratings is driven by the rise in loan-only capital structures,” UBS said in the report.
UBS estimates that 40 percent of the leveraged loan index is composed of loan-only capital structures now with 60 percent of B and CCC-rated companies supported solely by loans. NAVEX Global’s loan has no bonds, for example.
“We believe the prevalence of loan-only and cov-lite loans will make rating migration risks from B to CCC elevated as limited debt cushions and greater collateral uncertainty elevate potential credit losses,” UBS wrote.
A portfolio manager said that they are now investing on the assumption that there will be no junior debt cushion below the senior loans. This is fostering a more cautious approach.
“It’s a concern, especially without covenants,” the manager said. “It has led us to stay away from some cyclical companies.”