LCD's survey of U.S. leveraged loan portfolio managers shows a notable improvement in sentiment regarding the $1.2 trillion asset class, both with respect to market performance for 2020 and the severity to which loan default rates will peak in the coming year.

The unprecedented pace at which funding markets have normalized since the COVID-19 outbreak has mitigated initial fears that previously solvent companies would further elevate defaults in the cyclical downtown, though high leverage — which typically goes hand-in-hand with corporate defaults — remains an unresolved issue in the loan sector.

LCD's survey of buy-side market participants, conducted in late September, shows that loan portfolio managers expect the U.S. leveraged loan default rate will likely peak at more than double the 2.9% historical average, before beginning a descent in the second quarter of 2021.

More specifically, portfolio managers, on average, expect the default rate will peak at 6.6%. That is a notable improvement from the depths of the March crash. At that time, Street expectations pegged default peaks at 7%-8%.

A default rate of 6.6% would equate to some $78 billion in defaulted leveraged loan debt, exceeding the 2009 peak of $63.1 billion.

For year-end 2020, loan managers see the loan default rate closing out at 5.16%. This is slightly improved from a forecast in the second quarter of 5.32%.

Looking deeper into the crystal ball, loan managers, on average, expect the default rate will increase to 5.58% for the twelve months ending September 2021. In the second-quarter LCD survey, the average prediction for the 12 months ending June 2021 was 6.08%.

Back to black

In another read of investor sentiment, LCD's poll suggests the loan market will stage another rebound in the final quarter of 2020, with the consensus calling for an annual return at year-end 2020 of 1.23%. The year-end prediction given in the second-quarter survey was 0.49%. This would also mark a staggering recovery from the 12.37% loss the market endured in March 2020, when the COVID-19 pandemic began to take root.

As of Sept. 29, U.S. leveraged loans had returned -0.61% in 2020, after briefly breaking out of the red earlier in the month.

These predictions come at the end of a quarter that featured another big jump in the default rate — to the tune of nearly 100 basis points over the past three months — and a significant deterioration in earnings and leverage at leveraged loan issuers. These trends were met with record high-yield issuance in the bond market, as well as increased amendment activity for loans, which in turn permitted companies to extend their liquidity runways.

Looking at default activity in the third quarter, 11 issuers in the S&P/LSTA Leveraged Loan Index defaulted on $10.6 billion of term loans. Though still significantly elevated, this volume is down from the apocalyptic $23 billion of defaults from 27 issuers in the second quarter, which marked the highest quarterly volume since the first quarter of 2009.

The default rate by amount, at 4.17%, is up from 3.23% at the end of June and from 1.29% in the year-ago period. This brings default volume over the 12 months ended September to just shy of $50 billion, at $49.3 billion. This is the most for this metric since December 2009 and marks a 254% increase over the comparable period of 2019.

By issuer count, the rate, at 4.64%, is the highest since August 2010.

In a look at the source of defaults, Oil & Gas continues to significantly out-trend, with 28.4% of all defaulted loans in the Index this year coming from that sector.

Many in the industry already tried to right-size their capital structures in an effort to ride out what would turn out to be a historic and sustained low oil price environment, only to come back again for a second or third time, some regardless of the April plunge in prices. California Resources Corp., which in July filed for Chapter 11 bankruptcy protection, had previously completed a far-reaching uptier exchange in 2015. Fieldwood Energy Inc. defaulted in May upon failing to make payments on its term loans just a year after emerging from bankruptcy.

Ultra Petroleum also filed for bankruptcy in May after completing a distressed exchange in 2018, roughly one year after emerging from bankruptcy in 2017.

In defaults specific to COVID-19, well-known brands from brick-and-mortar clothing retailer Men's Warehouse, restaurant group Chuck E Cheese's, Hertz Global Holdings Inc., Cirque du Soleil and 24 Hour Fitness join a nascent-but-growing list of companies that have endured quick declines from the single- and double-B ratings brackets to bankruptcy or payment default.

Looking back at what was one of the weakest earnings quarters for corporate America, public companies within the S&P/LSTA Leveraged Loan Index reported an average 23% year-over-year decline in EBITDA, exceeding the prior peak decline of 18% recorded in the first quarter of 2009. That blow to earnings has left the credit markets in a relatively precarious position. Leverage soared to a record 6.4x on an average basis in the second quarter across the sample of loan issuers, up half a turn from the first quarter, and adding considerable distance from the healthiest reading of the now-derailed, decadelong economic expansion, or the 4.76x leverage reading in the final quarter of 2018.

A staggering 35% of the public filers LCD tracks within the Loan Index carried leverage of greater than 7x into the third quarter, nearly double the proportion a year earlier, and up from 14% at the cycle low for leverage, in the fourth quarter of 2018. The share of loans bid in the U.S. secondary market below 80 cents on the dollar, at 5.1%, though significantly down from the 56.8% peak on March 23, remains elevated, compared to the 2019 average of 3.25%. The share in deep distress, below 70 cents on the dollar, at 2.3%, compares to a 2019 average of 1.5%.

As a lagging indicator, however, these data points benefit from some context.

In a look at distress levels across sectors, among industries with a more meaningful index share of the U.S. leveraged loan market of above 1%, Oil & Gas once again takes the lead with a sector-level distress ratio of 24.8%. Distress remains elevated in spite of the spate of recent defaults that were flushed from the distress calculation.

Air Transport, coming in second at 17.1%, has seen distress fall from 55.8% in April. This sector had no loans in distress at the end of 2019.

Leisure and Retail, taking the third and fourth spots, have seen distress levels come down from the end of April. Again, this is largely on account of recent default activity than lower distress levels. Leisure in particular saw a big jump from minimal sector level distress at the end of last year.

Quality deterioration within leveraged loans was well documented before the pandemic, and the subsequent downgrade cycle further weakened the ratings mix. The share of index loans rated B- or lower at the corporate level stood at 32.45% at the end of September. This compares to just 11.2% five years ago. Loans from corporate issuers rated CCC or lower represent 10.1% of the Index in September, compared to just 3.5% five years ago.

The formidable wall for maturities does not start until 2024, when $271 billion comes due. Many issuers over the last decade, and in the shadow of the pandemic, have been able to considerably bolster their defenses by tapping the debt markets in record numbers to extend maturity profiles and refinance at historically attractive funding costs. With that, the 2023 maturity wall has dwindled to $114 billion, from $156 billion at the end of 2019.

With rising defaults comes a heightened focus on what investors can recover. To that end, using S&P's LossStats Data, LCD's analysis found that newly added instruments across bonds and loans in 2019 had an average discounted recovery rate of 66.3%. This has declined each year from 81% in 2016, notably as distressed exchanges have decreased and bankruptcies increased. The average discounted recovery rate for bank loans, at 74.4%, is down from a historical average of 79%.