On average, loan managers expect the loan default rate by principal amount to end 2013 at 2.15%, according to LCD’s latest quarterly buyside poll, taken in early September.
That forecast, which essentially matches August’s actual reading of 2.16%, compares to an average response of 1.81% when we last polled managers in early June. Since then, the default rate has trended higher.
Looking out further, managers expect the default rate to inch up to 2.26% by September 2014. (We asked managers to exclude from their forecasts TXU, which is the largest loan issuer in the S&P/LSTA Index. If the utility issuer files for Chapter 11 by year-end, as most participants expect, it will single-handedly push the default rate to 3.73%.)
As these forecasts imply, managers remain constructive on the default outlook. Indeed, the consensus suggests defaults for the balance of 2013 will be negligible. Moreover, the predicted rate for September 2014 means managers reckon that default activity during the next 12 months (again, excluding TXU) would increase only modestly, to $14 billion, from $11.3 billion over the past 12 months. Even then, managers think the default rate will remain inside the historical average of 3.2% at least through 2014.
This relatively bullish view is a product of the loan market’s still-healthy credit profile and the broader macro environment, which, by most accounts, is supportive, if not robust. Start with the credit landscape. Watch lists, managers say, remain short. And, in fact, LCD’s shadow default rate currently holds just three names. When TXU is excluded, the shadow rate drops to a mere 0.29%.
Likewise, the share of performing loans rated CCC+ or lower stood at 4.79% in early September (or 7.82% including TXU).
Another reason the near-term default outlook is benign is the lack of significant maturities over the next 18-24 months. The once-towering pre-2016 maturity cliff stood at just $21.6 billion as of Sept. 6, or 3.5% of total S&P/LSTA Index loans outstanding, with just $12.9 billion, or 2.1%, due through year-end 2014.
Two final points here. First, the combination of strong EBITDA growth since the recession ended and relentless work by issuers to refinance debt at lower margins has pushed the average cash-flow-coverage ratio of publicly filing Index issuers to 3.2x in the second quarter – the wide end of its historical range – from 3.0x in the first quarter.
Second, on the whole, the credit profiles of new deals are far less aggressive than those of the boom era, though leverage has risen from the draconian levels of the credit crunch. Thus, participants say, the market is not seeing a buildup of the structured-to-perfection deals that were so pervasive in 2006 and 2007, which created a significant population of highly vulnerable loan issuers. This chart tracking the average pro forma leverage ratio of the most geared 20% of LBO deals illustrates the trend:
Of course, managers worry that the press of dollars flooding into the loan market will result in leverage creep. This is a story as old as the financial markets, and arrangers say they are seeing screens that push leverage into the area of 7x or more, though the center of gravity remains 5-6x.
Turning to the macro picture, the story remains the same. Economists and market participants, by and large, think the recent low-grade GDP growth in the U.S. will persist.
In an Aug. 23 note, Beth Ann Bovino, U.S. Chief Economist for S&P Ratings, lowered her 2013 forecast for U.S. economic growth to 1.7%, from 2.0%, though she expects growth to accelerate to 2.9% in 2014 when the effects of the sequester burn off.
Of course, there are many risks to the forecast, including all the usual suspects: a geopolitical event, a sharp rise in interest rates, an escalation in Syria’s civil war, a spike in oil prices, a flare-up in Europe’s fragile sovereign-debt situation, or dysfunction in Washington related to the debt ceiling. Bovino, therefore, puts the odds of a recession at 10-15%.
For this reason, perhaps, investors continue to price in an imputed default rate of 3.6%, based on today’s average Index discounted spread of L+482. The imputed rate is down significantly after several years of peace and prosperity across the capital markets, but it remains wide of both the current default rate and the forecast for the next year.
– Steve Miller
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