We are re-publishing and annotating an article by S&P Global Market Intelligence regarding slowing growth in the EBITDA of larger leveraged loan borrowers. We’ve highlighted key passages and added our own thoughts and findings for the BDC sector, whose borrowers overlap with the group that is the focus of this article. The BDC Reporter has been concerned for a few months about a marked deterioration in credit quality in the sector. This article is another attempt – along with commentary made in our most recent BDC Common Stocks Market Recap – to show the variety of data sources that are causing our concern. 

Earnings at leveraged loan issuers slump prompting more scrutiny for $1.2T market

“Issuers of U.S. leveraged loans recently posted a second straight quarter of razor-thin earnings growth and decline in cash-flow coverage, as the business-cycle dashboard flashes warning signals regarding this longest-ever period of U.S. expansion.

The softening of key metrics is of particular concern to participants in the nearly $1.2 trillion leveraged loan space, which entails credits to riskier, speculative-grade borrowers. Over the past decade, the popularity of covenant-lite loans in this market has skyrocketed, while other investor protections traditionally found in leveraged loans have evaporated, amid intense investor demand.

Market defenders have maintained that those eroding investor protections are less of an issue than they might appear, as long as corporate earnings remain strong and issuers are well-positioned to service what in many cases is considerable debt. Now that the economy appears to be slowing, however, that theory might start to be tested more often, with the potential for a spike in defaults, observers say.

Specifically, EBITDA growth across issuers in the S&P/LSTA Leveraged Loan Index that file results publicly was a marginal 2% in the second quarter, down from 3% in the first quarter, and well off the 9%–13% growth rates over the four quarters last year, according to LCD. Revenue growth across the sample slipped to 5% from 6% in the first quarter, marking a fourth straight sequential decline. That is down from growth rates of 9%–14% in 2017 and 2018.

The sample includes 202 issuers that account for approximately 18% of the Loan Index, by par amount outstanding.

BDCR Notes: The decline in EBITDA growth discussed above is consistent with what we’re hearing from several BDC managers on the latest round of Conference Calls. Earnings season only closed out on September 10, but most of the funds reported in early August. For example, here’s what Ares Capital (ARCC) – far and away the largest single public BDC – said about the EBITDA trends in its portfolio company group on July 30, 2019:

I think we’re seeing the same slowing growth narrative that you’re seeing in the newspapers. The numbers that we laid out for Q2 about EBITDA growth in the portfolio is a 4% number for Q2, which was 5% in Q1 and 7% at this time last year.

Even more telling, but using different data, is the change in under-performing investments at FMV. Not every BDC maintains an investment portfolio rating system but 29 of 46 do and we’ve collated the numbers for IQ and IIQ 2019. Despite booking substantial Realized Losses in the second quarter, which should reduce the value of under-performing assets, the numbers still increased. By our count the under-performing investments in these 29 BDCs increased by 9.9% in the IIQ 2019 to reach $4.16bn out of $52.2bn in total portfolio assets. 

As a percentage of the total investment assets, the under-performers amounted to 8%, but varied widely from BDC to BDC. 

The results for loan issuers generally tracked with tepid growth across the S&P 500. With 462 companies reporting as of Aug. 15, the blended growth rate for earnings was just 1.7%, according to S&P Global Market Intelligence. Offsetting growth in earnings for the real estate, financials, healthcare and consumer staples categories were year-to-year declines for consumer discretionary, utilities, industrials, energy, materials and communication services. Loan-issuer sector progressions were broadly similar to the S&P 500 experience.

BDCR Notes: We’ve begun to generate enough data to speak quantitatively about what’s happening to BDC borrowers by sector. We’re working with Advantage Data on a project to be able to drill down to component companies by relatively narrow industry segments and speak to credit performance therein. Until that’s completed, we do have some idea what industry segments are performing poorly by looking at the still incomplete company data by category. Of late, logistics (principally trucking); oil field services; oil & gas exploration; coal mining; retail; restaurants – and both surprisingly and worryingly – healthcare, all of which have been showing signs of strain. 

The risk of an earnings recession will put credit metrics under harsher scrutiny after trailing growth blunted the impact of mounting gross debt. Loan issuer leverage, on a weighted-average basis, increased one-third of a turn from the first quarter — to 5.59x from 5.26x — while cash-flow coverage declined 34 basis points sequentially, to 2.95x, according to LCD.

BDCR Notes: We don’t have equivalent data for BDC company leverage, but with continuing intense competition for loans between the BDCs themselves, as well as with bank and private lenders it’s likely leverage levels remain elevated across the space. Certainly, every BDC – almost without exception – continues to complain about pressure on terms and spreads.

At present, both indicators are modestly better than their trailing-12-quarter averages, or 5.67x for leverage and 2.93x for cash flow coverage. But there are now more issuers operating at the extremes of credit tolerances, including a nearly three-point sequential increase in the percentage of loan issuers with leverage of greater than 7x, to 18.3%. The percentage of loan issuers with cash flow coverage of less than 1.5x swelled 113 basis points from the first quarter, to 20.6%.

Coming into the third quarter, loan portfolio managers continued to see life left in this aging credit cycle, according to LCD’s quarterly loan-manager survey. While they bumped up their default-rate forecasts through 2020 by 12 basis points from the first quarter, to 2.7%, respondents again pushed out the timeline for when they believe the market will breach the 2.92% historical average. Just 17% predicted this to be a 2020 event, compared to 25% at the March quarterly poll. Fewer managers (58%) see this happening in 2021, versus 75% at the March read.

BDCR Notes: This is a very important survey and explains why both lenders and investors in lenders do not appear to be reacting to the worsening fundamentals. They appear to believe that there is a wide margin between where leveraged lenders are and when actual difficulty repaying debt will occur. That suggests there is plenty of time before any evasive or defensive action is necessary and might explain why high yield, floating rate loans and BDC stocks are all trading at relatively high prices. The BDC Reporter, though, is not so sure that current credit conditions are as benign as the survey respondents believe and that matters could not get worse much faster, even by the end of 2019. 

This pessimism is partly derived from our ongoing review of every BDC portfolio, which involves looking at every company on the books and rating both the credit trend and the outlook. In terms of trend, we’ve found 23 of 30 BDCs reviewed in this way to be declining and 7 unchanged. None materially improved. 

In terms of credit outlook, we rate 6 as GOOD, 5 as FAIR and 19 as POOR. Those are not encouraging ratings.

But at least some of those views may have dimmed in recent weeks. S&P Global Economics’ latest Business Cycle Barometer (BCB) reading showed further deterioration in leading indicators as of mid-August, as the term spread indicator turned negative to reflect curve inversion, and both freight transportation and the ISM (manufacturing) new orders index turned neutral from positive. The group’s qualitative assessment, combined with calculated odds based on financial market spreads, puts the risk of a recession in the next 12 months at 30%–35%, up from 25%–30% three months earlier.

Myriad factors inform the more pessimistic viewpoints, including weaker factory sectors in the U.S., China, and the eurozone; tariffs; the increasingly complicated Brexit situation; and geopolitical tensions in Hong Kong, Argentina, Iran, India, and Pakistan.

BDC Reporter Notes: We don’t begin to be able to estimate when a recession will occur. However, we’re pretty sure – based on having lived through prior contractions – that by the time the economic numbers confirm a recession is underway much of the damage from a credit standpoint will have been done.  The Great Recession officially began in December 2017  (and lasted through to 2019), but BDC portfolios began to reflect a surge in unrealized write-downs two quarters earlier. By the time non accrual rates jump back to their historical averages we could have experienced several quarters of credit deterioration. 

What we are looking as early warning signals are drops in borrower earnings;   an increase in technical, non-payment  defaults (often reflected – ironically enough – in a surge in fee income) and an increase in the number and volume of under-performing assets, especially in Category 3 of our 5 point scale, i.e. our Watch List. By the time those credits – and the many others that may follow – start to need restructuring, emergency advances or move to non-paying status (ratings 4 and 5) it will be too late. Some of those early warning signaling is already occurring. It may – like a threatening cloud – just move away or take a very long time arriving, sparing all of us getting out our umbrellas prematurely. More likely, though, is that some rain going to fall. In certain segments of the market that’s already underway and could get worse. 

LCD is an offering of S&P Global Market Intelligence. S&P Global Ratings is a separately managed division of S&P Global”.