Are rising default rates cause for concern?

Leveraged finance defaults are rising as the impact of COVID-19 is felt, but covenant-lite terms, government intervention and support from financial sponsors have mitigated fallout from the pandemic

Leveraged finance default rates increased during 2020 as COVID-19 lockdowns impacted corporate earnings and the capacity to service debt.

US institutional loan defaults climbed to 3.9% on a trailing 12-month basis in June, according to Debtwire Par. This is the highest level since the 2008 financial crisis and puts the year-to-date default figure at US$44 billion. High yield bond default rates also ticked higher, rising from 4.6% in May to 5.1% in June.

European default rates remained below 2% according to Debtwire Par, mainly thanks to subsidized government loans and loan guarantees.

Companies boost liquidity

While COVID-19 has had an immense impact on global economies—for example, the IMF forecasts a 4.9% contraction in global growth and GDP of -8% in advanced economies—default rates remain significantly lower than the 10%-plus levels observed in 2009 following the global financial crisis.

Despite the disruption to capital markets, borrowers were able to turn to their 2008 credit crunch playbooks for survival strategies, as well as more recent document innovations, fueled by the prevalence of cov-lite and incurrence covenant structures. Companies moved quickly to shore up liquidity by drawing down on revolving credit facilities and, in some cases, were able to tap high yield bond markets post-lockdown for additional funding.

Financial Times research shows that more than 130 companies in the Americas and Europe drew down in excess of US$124 billion from existing credit lines in March 2020 alone.

Cruise line operator Carnival, hoteliers Hyatt and Hilton and food multinational Mondelez, meanwhile, were among the companies able to boost liquidity during lockdowns with successful bond issues.

Given the increasingly sizeable proportion of loans done on cov-lite terms pre-COVID-19, the risk of tripping covenants and going into default was significantly reduced.

According to Debtwire Par, for example, well over half of institutional US leveraged loans issued since 2014 have been cov-lite while the same can be said for more than three-quarters of institutional leveraged loans issued in Europe since 2017.

Incumbent lenders have also taken a generally pragmatic approach to working with otherwise sound borrowers who came under financial pressure as lockdowns knocked earnings.

Forbearance, payment holidays and covenant suspensions or waivers have been available to stretched companies. The Ford Motor Company, for example, recently negotiated a 12-month maturity extension to US$5.35 billion of loans, while Irish aircraft lessor NAC won approval from a group of its lenders to defer the payment of interest and principal on US$6 billion of its debt.

Financial sponsors, meanwhile, have in some cases helped to shield their portfolios by providing credit support and guarantees for third-party financing.

As long as companies have been able to lock in liquidity, it has been possible to ride out the storm.

Distress hotspots

Most of the credits that defaulted or undertook restructuring this year were either distressed before the pandemic or in sectors hardest hit by lockdown measures and travel restrictions.

Retailer J.Crew, for example, recorded a default in Q2 2020, but had been in restructuring processes for months prior. Similarly, circus franchise Cirque du Soleil had to cut staff at the end of 2019 as part of a corporate reorganization. Lockdown conditions then stopped the company from performing altogether and tipped the business into default with a missed payment in May.

Chesapeake Energy is one of many energy companies that defaulted during lockdown, as the oil & gas industry was buffeted by falling oil prices, a supply glut and lower demand.

Mixed outlook ahead

The relatively low levels of defaults so far this year, and the fact that most troubleshooting has been limited to specific sectors and scenarios, has come as a pleasant surprise. However, a spike in default levels in the second half of this year and into 2021 remains a distinct possibility.

The gradual easing of lockdown measures has helped companies get back to business, but local virus flare-ups and the potential for a second wave are reasons for caution.

It is also unclear how resilient companies will be when government-backed financial support measures unwind, particularly in Europe. More defaults could emerge as these safety nets are removed. Moreover, while being a vital cash conservation measure deployed in response to COVID-19 fallout, the recent reductions in CapEx spending will undermine medium-to-long-term financial performance in a way that leaves business susceptible to future shocks.

Fitch Ratings is already forecasting annual default rates of around 4% to 5% for European high yield bonds and leveraged loans, and it expects default rates to continue climbing in 2021 as the full extent of the pandemic’s impact on economies filters through debt markets. A poll of US loan managers by S&P LCD, meanwhile, shows that, on average, managers are preparing for default rates in excess of 5% this year.

Default rates have been encouragingly low so far, but the market remains unpredictable. For now, uncertainty is the norm.

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