Amid distress, European leveraged loan, high yield defaults remain low

Signs of stress continue to emerge in Europe's high-yield bond and leveraged loan markets, even as default rates, at least for now, remain low.

The strain is most obvious in the secondary markets.

The percentage of credits in the Morningstar European Leveraged Loan Index (ELLI) that are distressed (those priced below 80 in the trading market) rose to 6.5% by Sept. 30 — the highest level since May 2020, in the aftermath of the pandemic sell-off — while the share of credits priced between 80 and 89.99 rose to nearly 31%. This was the highest percentage for this latter bucket since June, and before that, March 2020. 



In the high-yield market, the signs of distress are more acute. The weighted average price of distressed bonds in the Morningstar Eurozone High Yield Bond GR EUR Index (as defined by OAS above 1,000 bps) stood at 67.9 on Oct. 10, while the average option-adjusted spread (OAS) for the distressed subset was 1,620 bps.

The number of bond issues in this index categorized as distressed (those trading at an OAS of 1,000 bps or above) stands at 79, meanwhile, for a 9.16% share of the index, including securities rated as low as CCC- and as high as BB+.



Price point
Falling cash prices in the secondary bond market have also produced a substantial discount in reoffer prices for new bonds, although the thin trickle of recent deals has established higher pricing points than the average low of 92.7 in the third quarter, according to LCD data. Fixed-rate deals for Lottomatica and Verisure priced at par, and Tendam Brands recently completed a 5.5-year floating-rate note with an E+750 margin, at 93. 


Deals for borrowers such as 888 Holdings and Manuchar in July landed in the 80s as underwritten deals which looked to have priced through their deal caps, although retailer BestSecret also priced an E+600 FRN at 1% and 85 on a best-efforts basis.


“When the sector as a whole is trading below par, the bar for investing in new issue opportunities tends to be much higher as investors tend to focus more on pull-to-par when looking at relative value,” Pierre Beniguel, portfolio manager at TwentyFour Asset Management, wrote in a July blog post.

While primary market activity has improved despite various difficulties, deals in FRN format are still coming with low cash prices given the thin available liquidity in CLOs. Tendam, for example, had sounded out investors with price whispers at a coupon of E+900-925, according to sources, but eventually opted for a lower coupon and larger discount.



Turning back to loans, the share of credits priced above 90 in the ELLI fell to 63% in September, from 86% in August, while credits priced above 98 made up only 1.07% of the index. Nothing has been priced above par since April.

Meanwhile, the ratio of downgrades to upgrades increased to 2x on a rolling-three-month basis to the end of September, from 0.8x to the end of August. This is the highest the ratio has been since February 2021.



Weakest Links
There have also been changes to LCD’s loans 'Weakest Links' cohort that indicate greater stress (defined as issuers rated B- or lower by S&P Global Ratings, with either a negative credit outlook or on watch negative). Looking at the current group (based on a second-quarter reading), 31.3% earned that designation in 2022 — specifically in the second quarter — while 18.8% moved into the category in 2021, 25% in 2020, 18.8% in 2019 and 6.3% in 2018.



Two of these credits were flagged by S&P Global Ratings as having “liquidity and refinancing risk,” namely Holland & Barrett and Hurtigruten. Meanwhile, the outlook for Wittur was revised to negative due to weaker operating performance, according to the ratings agency. There are also concerns over “high debt leverage” for ASP Unifrax Holding after the acquisition of an additional 25% stake in Chinese manufacturer Luyang, while Diebold Nixdorf's business “experienced significant operating challenges including inflationary cost pressures amid persistent supply chain issues and macroeconomic uncertainty that we expect will likely continue,” the agency said.

By contrast, the majority of exits from the Weakest Links were by those names in the travel and leisure sector that had seen an improvement in operating performance since pandemic-related restrictions were loosened. There was also one default, from Schur Flexibles.

As well as the increase in downgrade rating actions, there is also evidence of especially severe downgrades that appear to have caught bond investors by surprise. German retailer Ceconomy, for example, was dealt a two-notch downgrade of unsecured debt to Ba3 by Moody’s in September, which caused its bonds due 2027 to fall by roughly nine points.

This week, S&P Global Ratings downgraded Casino Guichard-Perrachon and its unsecured debt by two-notches, to CCC+ from B, cut the firm's secured debt from B+ to B-minus, and changed its perpetual debt rating to CC. Although bonds issued by the French supermarket group fell by as much as two points on the news, the market reaction was more evident in the company's stock price, which fell as much as 11.5% on the morning of Oct. 10.

Moody’s also this week downgraded Matalan's corporate rating by two notches, to Caa3 from Caa1 — although this came in line with market expectations in light of an ongoing restructuring of the UK retailer.

When looking at market distress it's worth noting the covenant-lite nature of the European leveraged loan market, where there may not be levers for lenders to take action when companies experience difficulties. Furthermore, borrowers took advantage of highly liquid debt markets to refinance following an abrupt recovery after the initial Covid-19 sell-off, thereby boosting the health of their balance sheets.



ELLI defaults
Despite the difficult backdrop, actual defaults in the ELLI — which are usually a lagging indicator — have so far remained low. Indeed, to the end of September on a 12-month rolling basis this measure declined to 0.58% based on issuer count and 0.43% on principal amount.



Although a dramatic spike in loan and bond defaults has not yet occurred the warning signs are growing, and access to capital for leveraged borrowers is getting tougher, with financing costs skyrocketing for leveraged credits. For euro-denominated single-B TLBs, pricing in the third quarter shook out at an average spread of 515 bps over Euribor, according to LCD, with a yield to maturity of 7.44%. This compares to 452.3 bps and 5.38% respectively at the end of the previous quarter, and 423 bps and 4.45% at the end of 2021. Loan pricing hadn’t reached these levels since 2Q12 for spreads and 4Q11 for yields, which were impacted by the eurozone debt crisis.



Meanwhile in bonds, the average yield on single-B rated notes in Europe stood at 10.17% for the three months ended Sept. 30, according to LCD data, up sharply from 5.27% in the first quarter.



Taking a final indicator, the number of European loan deals to flex wider in September produced the highest monthly count since March 2020 (discounting the holiday-impacted month of August).



Featured image by Igor Salnikov/Shutterstock

This article originally appeared on PitchBook News