The second quarter brought a fresh look at the fallout from the COVID-19 crisis for U.S. leveraged loans as ratings damage hit at record speed and the first of the pandemic-related defaults began to trickle through.

Second-quarter default activity in institutional loans — the kind purchased by CLOs — though rapidly rising and topping prior milestones, was dominated for the most part by pre-pandemic situations, however.

A record 11 defaults in April totaling $6.90 billion, followed by a six-year monthly high of $10.54 billion of defaults in May, helped finally push the S&P/LSTA Leveraged Loan Index past its 2.85% historical default average for the first time since 2015.

June's $5.70 billion of defaults brought the second-quarter total to $23.1 billion across 27 Index issuers, the highest quarterly volume since 2009's first quarter.

By issuer count, at 3.70%, the default rate is at its highest since September 2010 and compares to 2.02% in the first quarter of the year.

By amount, the default rate ended the second quarter at a five-year high of 3.23%, rising markedly from 1.84% at the end of the first quarter.

Among companies affected by COVID-19 to default during the quarter, Hertz Global Holdings Inc., Cirque du Soleil Inc., 24 Hour Fitness, Fieldwood Energy, Technicolor, CEC Entertainment Inc. (Chuck E Cheese), and Covia (Fairmount Santrol), each of which was rated in a single- or double-B capacity before the global outbreak.

Big capital structures from Intelsat to Frontier Communications Corp. also folded. The former did so to lighten its nearly $15 billion of funded debt obligations and facilitate participation in the accelerated clearing of C-band spectrum, the latter to shed the weight of its $17.5 billion debt burden, taken on in large part through a spate of acquisitions over the past 10 years.

Retail also added to the list of milestones breached this quarter with defaults from prominent chains J.Crew Group Inc. and J.C. Penney pushing the retail sector-level default rate to a record high of 13.64% in May.

Telecommunications was the largest contributor of defaults these past three months, at 20.3%, followed by oil and gas at 13.3% and retail at 12.4%.

Bracing for impact
While the crisis might not yet show significant loan default activity, as a leading indicator, the impact of a record few months of ratings damage is expected to unfold in rising default rates.

Through June, 35% of the loan market by par amount outstanding (at the facility level) had received a ratings downgrade, representing $411.1 billion of the $1.169 trillion of rated loans at the end of 2019.

On a three-month rolling calculation, the downgrade count of loan facilities in the S&P/LSTA Leveraged Loan Index outpaced the rate of upgrades by a staggering 43 to 1 in May, before slowing from this record level to 18.4x in June.

During the global financial crisis, the three-month rolling count in favor of downgrades peaked at just 8.45x.

Perhaps most important, as previously mentioned, rising downgrades typically precede a period of rising defaults. The accompanying chart shows how the default rate and the downgrade/upgrade ratio have cycled historically. The downgrade/upgrade ratio averaged 2.7x in the six months before the November 2009 default peak of 8.25% (on an issuer basis).

The fallout from this massive onslaught of downgrades is multifaceted. CLOs are exceeding their structural limits for lower-rated debt at eye-watering numbers. The repricing of downgraded companies' debt, and the increasing challenge for lower-quality loans to find a home, will undoubtedly make traditional funding more prohibitive for these issuers, while the ratings quality mix of the leveraged loan market continues to worsen.

While the count of loan facility downgrades by S&P Global Ratings slowed to 90 in May, and 50 in June, it followed a record 228 downgrades in April and a previous record of 114 in March. Even with the full effects of COVID-19 and its harm to the global economy still unknown, the past four months alone have outpaced the full-year 2019 downgrade total of 364 loans by 32%.

That figure was up from 244 in all of 2018, and 231 in 2017.

Of all the downgrades in the second quarter, by issue count, the highest tallies came from business equipment and services (12.23%), leisure (10.05%) and industrial equipment (8.15%). Year-to-date, leisure leads in downgrade activity, at 11.67%, despite making up only 4.09% of the index by loan count.

autos and hotels and casinos, meanwhile, did not feature in the top 15 of downgraded sectors before the COVID-19 crisis. The respective year-to-date downgrade shares are now 4.44% and 4.26%.

This downgrade cycle has also further worsened the ratings mix of the leveraged loan market, with the share of issuers in the S&P/LSTA Leveraged Loan Index rated B- or lower climbing to 33.8% as of June 26, the highest reading ever.

This figure stood at just 10% five years ago.

Loans whose issuers are rated CCC, CC or C, a particular problem for collateralized loan obligations, make up a record 11% of the index, significantly higher than the 2.9% of the market five years ago.

Distress eases
In further forward indicators, the distress ratio remained elevated for much of the past three months. However, thanks to a late May-early June rally in risk prices, and the cushion of collateral in loans against the outperformance of high-yield bonds, distress levels have come a long way from the 57% peak on March 23.

After averaging almost 20% in April, and 15% in May, only 8% of performing loans were priced below 80 at the end of June. This compares to 4% at the end of 2019.

Among the sectors with a more meaningful index share (above 1%), oil and gas, leisure and nonfood retail sport the highest distress ratios at the sector level.

This analysis was written by Rachelle Kakouris, of LCD Research