Oct 13 (Reuters) - Global speculative-grade default rates may be falling, but ratings agencies are warning that the statistics are misleading due to structural changes in the leveraged loan markets since the last downturn.
Ten years on from the advent of the financial crisis, bankers and investors agree that the transatlantic loan markets are bigger and better. Private equity buyouts are backed by substantial equity cheques, interest coverage ratios are healthy, and default rates are low.
Concern is growing, however, about the increased use of loan-only deals, aggressive covenant-lite structures and weak loan documentation, which could double default rates at the lower end of the credit spectrum in the next downturn, according to Moody’s.
“The last default cycle wasn’t bad for the leveraged loan market, but the market’s changed. Protections are weaker, deals are more aggressive and we anticipate that the default cycle could be worse as credit quality is lower,” said Christina Padgett, Moody’s head of leveraged finance.
Covenant-lite loans now make up 75% of the US market, compared with 24% in 2012, according to Moody’s. In Europe, 72% of leveraged loans are covenant-lite, compared with around 15% in 2007, according to S&P.
With few checks and balances, covenant-lite loans take longer to sour, which means that the next default cycle could be longer and more severe. Banks’ increasing willingness to do loan-only deals could also hurt recovery rates.
Borrowers have used cheap and flexible senior debt to cut interest payments in the past two years, but weak documentation is likely to lead to lower recoveries in the next default cycle, Edward Eyerman, head of leverage finance at Fitch, said in a recent report.
The increased use of loan-only senior debt is also reducing the size of debt cushions, which traditionally take the first hit in defaults, and is likely to increase the number of defaults.
“There could be a lot more rated defaults than the last default cycle,” said David Keisman, a senior vice president in Moody’s corporate finance group.
Moody’s calculates that 24% of US deals were loan-only covenant-lite deals in 2016, with an average equity cushion of 21.7%, compared with 5% loan-only deals and a cushion of 33.2% in 2005-2010.
The rise of loan-only deals means that senior leverage is making up a higher proportion of total leverage in buyouts. Total leverage in the first half of 2017 was 4.8 times according to S&P, of which 4.5 times was senior leverage, only just below the 4.6 times recorded at the peak of the market in 2007.
There are also more low-rated loans for smaller issuers that are more vulnerable to economic shocks. The percentage of US leveraged loans rated B3 and below was 36% in July, already past the 33% seen at the peak of the default cycle in 2009, according to Moody’s.
Although few expect the market to get ugly any time soon, some investors sense that the market is only delaying the next downturn, which could render it more dangerous.
Moody’s said this week that its forecast speculative-grade default rate in Europe was set to fall from 2.4% currently to 1.9% at year-end.
“Many issuers have long-dated maturities and, as long as they have enough liquidity to service, their debt defaults will remain low,” said Sandra Veseli, a senior managing director at Moody’s.
Fitch’s Eyerman calculated that even a 200bp rise in interest rates is unlikely to stress credit profiles, given the size of issuers’ debt service headroom.
Covenant-lite loans have historically posted better recovery profiles, as only the strongest companies were typically able to issue them, but that has changed drastically.
Javier Peres Diaz, head of European loans at BNP Paribas Asset Management in Paris, said that there was uncertainty about how relevant historical default figures and recovery rates were given this change.
Another investor went further, suggesting the next downturn would likely see companies skipping the default phase and going straight into bankruptcy.
Toys R Us did exactly that when it filed for Chapter 11 protection in the US last month. The US retailer faced no imminent debt maturities, but said that after a seven-month effort it had failed to address its $5.2bn debt problem.
That largely stemmed from KKR’s US$6.6bn buyout of the firm in 2005, which required interest service alone of US$400m a year, according to Reuters.
Moody’s is predicting that more debt-for-equity swaps and distressed exchanges are likely and that borrowers could have to return for several debt restructurings.
“Our research shows the distressed exchanges haven’t worked, really,” Keisman said. “They’ve typically just bought time.”
In addition, the encroachment of covenant-lite loans into the lower, less liquid end of the market is countering many investors’ argument that the ability to trade out of certain credits mitigates the need for further creditor protection.
“Liquidity won’t be there when we need it in the market,” said Jonathan Bowers, partner at CVC Capital Partners. “And it seems with each new deal lawyers are pulling out more protection.”
Several recent deals have met with stronger resistance from potential buyers over weak documentation and the ability to add additional debt, including US life sciences company Avantor and UK events firm Clarion.
Despite these cases, the sheer amount of cash chasing yield in the market today suggests that a return to stronger covenants is unlikely.
“It may already be too late,” said a banking partner at a law firm in London. (Editing by Tessa Walsh)