Credit quality declines for European leveraged loans amid ratings shift

The credit quality of Europe’s leveraged loan universe has been declining as weakening economic conditions continue to pressure the credit metrics of lower-rated issuers, and this dynamic has pushed the share of loans rated B-minus or lower to nearly a quarter of the now-record €278 billion outstanding in the Morningstar European Leveraged Loan Index (ELLI).

The ratings composition of the ELLI has changed dramatically since the start of the Covid pandemic. The share of B-minus rated loans by par amount stood at 20.4% as of December 2022, compared with 12.7% in January 2020 on the eve of the pandemic. While this is down slightly from a Covid peak of 22.7% in December 2020, the general trend over the past five years shows this share has steadily increased since the 4.7% post-Global Financial Crisis low recorded in October 2017.

Mirror writing
The trend is mirrored further down the ratings spectrum. Though the share of CCC/CC/C rated loans by par amount fell back to 4.29% in December, from a pandemic-era peak of 8.72% in March 2021, the level is still above the post-GFC low of 1.20% in June 2017, and the June 2019 reading of 1.58%.

Overall downgrade pressure peaked in October 2022 when the ratio of downgrades to upgrades reached 4.5x, for the highest such reading since September 2020. The historic high was reached in the aftermath of the initial Covid shock in April 2020, at a whopping 56x.

Market growth as measured by the ELLI has slowed after a period of rapid expansion. In 2019 the index reached a milestone of €200 billion (as measured by outstanding deals), having doubled in just four years. This expansion took the total size of the index from a post-GFC year-end low of €96.92 billion in December 2015, to €213.64 billion at the end of 2019.

Dislocation across institutional markets for much of last year resulted in a slowdown of the index growth rate to 3.45% across 2022, down from an average annual growth rate of 18.7% across the 2016-2021 timeframe. Nevertheless, the total size of the index by year-end stood at a record €278.12 billion.

The number of issuers in the index declined for the first time in ten years.

The net change in the number of issuers with facilities tracked by the ELLI declined by six in 2022, compared with an increase of 35 in 2021. The last time the number of issuers declined was in 2012, when the market was gripped by the eurozone debt crisis.

Money tree
The slowdown in growth is partly due to the lack of new-money deal volume. New-issue loan volume in Europe reached €58.2 billion in 2022 from 110 loans, which is 55% lower than the 2021 total, while institutional new-issue loan volume reached €35 billion, which is 69% lower than 2021. Of this, refinancings only accounted for 23% of new institutional issuance, at €7.94 billion.

New-money event-linked primary issuance is expected to remain thin in the near term, meaning the market is set to focus on refinancings for the first part of 2023. Out of the ELLI maturity pressure peaks in 2028. What’s more, work has already been done to address maturities, and — compared with December 2021 — loans maturing in 2023 have been reduced by 46%, and 2024 maturities trimmed by 33%.

As a percentage, just 1.3% of the ELLI is due in 2023 and another 7% in 2024, stepping up to 15.1% in 2025 — but there are still considerable near-term maturities compared with previous years. At the end of 2018, just €2.48 billion was due in the next two years, but by December 2022 this figure had climbed to €22.69 billion. Turning to longer-dated paper, at year-end 2018 only €9.75 billion was due in the next three years, but by December 2022 this measure had climbed to €64.32 billion.

Of the maturities before 2024, which total €22.7 billion, some €8.77 billion (38.6%) are rated CCC+ or lower (or not rated), while €6.2 billion (27.4%) are rated B-. For the €41.6 billion maturing in 2025, some €5.93 billion (14.2%) is rated CCC+ or lower (or not rated), and €14.8 billion (35.5%) is rated B-.

Of these near-team maturities though, not all are distressed. B/B2 rated issuer Nord Anglia represents the largest sponsor-backed loan in the ELLI with a 2024 maturity, as it has roughly $1.88 billion — mainly in euro term loans, but also some dollar loans — due September 2024. This borrower was first out the blocks in the European market this year, launching a roughly $1.9 billion-equivalent term loan cross-border refinancing and extension last week.

Nord Anglia is a well-followed issuer in the popular education sector, but it still faces a significant increase in its cost of debt. Price talk for its up-to-$1.4 billion-equivalent term loan B due January 2028 is E+475-500 with 0% floor offered at 97, and the deal extends the existing loan by 3.25 years, suggesting a yield of 8.02-8.29%. This pricing compares with an original 2017 deal at E+325 with a 0% floor and 99.75 OID, yielding 3.38%.

Price dispersion
The cost of financing will usually be higher for those borrowers in more recession-exposed industries, amid widening price dispersion across sectors and rating cohorts. Indeed, double-B credits were the best performers in 2022 as recession fears grew, with a return (excluding currency) of 0.64%. Triple-C loans meanwhile were the worst performers, posting a loss of 9.66% for 2022, while single-B loans lost 3.29%.

The flight to quality has also resulted in higher-rated borrowers taking a larger share of the primary market. In 2022, BB rated borrowers accounted for 23.1% of total new-issue volume, which is the largest annual percentage on LCD's records.

However, the vast majority of this supply equates to bank-provided pro-rata volume that does not trade on the ELLI. Looking at institutional volume only, single-B issuance accounted for 84% of total new-issue volume in 2022 — the highest figure recorded since LCD started tracking this data back in 2000.

This situation arose as relationship banks stepped up to provide sizeable facilities that would in more normal times have ended up as liquid institutional deals. The merger of Orange’s Spanish business with MasMovil, for example, is backed by a bank-provided €6.6 billion non-recourse loan, while French telco Iliad signed a €5 billion syndicated loan in the summer that was in December partially taken out via a €750 million, 4.5-year bond issue.

Underwriters say bank lenders have always been ready to support strategically placed companies in the double-B area, but have generally not been needed due to surging institutional demand. The collapse in this bid allowed banks to step in again, and annual European institutional volume finished the year at its lowest since 2012 at €35 billion, while bank-provided pro-rata volume finished at its highest since 2014.

Bank interest for single-B and lower-rated credits is far less certain. Arrangers say rising rates in the past year have resulted in pockets of bank interest in leveraged credit from commercial banks in regions such as Asia. This bid is still unreliable though, and can dissipate as quickly as it arrives, arrangers explain. As a result, institutions will be needed to meet the maturity requirements of lower-rated names which — in the absence of new-money deals — are set to remain a key feature of Europe’s loan universe.

Featured image by Marc_Espolet/Shutterstock

This article originally appeared on PitchBook News