The run of strong cash-flow growth for leveraged loan issuers continued in the first quarter. Among S&P/LSTA Index issuers that file publicly, EBITDA grew 14% year over year, versus 10% in the fourth quarter, according to data from S&P Capital IQ. Leveraged loan issuers now have put up 11 straight quarters of muscular performance since the recession ended in June 2009.
The increase in cash flow bolstered coverage ratios across the leveraged loan universe. The weighted ratio of EBITDA less capex to cash interest, for instance, averaged 2.2x in the first quarter, which is within the recent band of 2.1-2.4x.
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This trend is part of the broader theme across corporate America, which has made the most of the modest recovery to drive earnings growth. The operating earnings of companies in the S&P 500, for instance, were up 7.4%, according to S&P Capital IQ’s Bob Keiser.
Despite the ongoing EBITDA expansion, the loan default rate has ticked up to 0.56% this year following bankruptcy filings and out-of-court reorganizations by Coach America, Tensar, Hawker Beechcraft, and Bicent, from a minuscule 0.21% at year-end.
Participants think this theme will persist in the quarters ahead. On the one hand, a combination earnings growth and liquid capital markets will depress default activity across the general leveraged loan population, keeping the rate inside the historical average of 3.4%.
On the other hand, there remain troubled situations that could nudge the default rate higher. For example, 5.1% of performing S&P/LSTA Index loans have corporate credit ratings of CCC+ or lower and are bid at less than 70 cents on the dollar (this dubious list is dominated by TXU).
For this reason, perhaps, the consensus projection among buyside players is for default rates to push to 1.6% by year-end 2012 before rising to 2.7% in 2013, according to LCD’s latest manager survey, from mid-March.
This forecast, in general, assumes that the economy will continue to grow modestly, bolstering corporate earnings. That lines up with the Street’s view. According to Keiser, stock analysts expect S&P 500 earnings to grow 7.4% in 2012 and 11.6% in 2013.
Of course, the outlook fraught with risks. These include (1) an escalation of Europe’s sovereign debt crisis – a possibility that over the last 10 days appears much more worrisome; (2) a geopolitical event in the Middle East; (3) a hard landing in China; (4) a government shutdown inWashington when the debt-ceiling issue reemerges in early 2013; or (5) a heretofore unseen exogenous shock.
With these factors in mind, S&P’s deputy chief economist, Beth Ann Bovino, puts the chance of a recession at 20%. The good news here is that Bovino has lowered her recession possibility forecast from a peak of 40% from last fall, when recession fears soared amid a raft of negative events. The bad news is that a one-in-five chance of recession reflects the fact that so many significant risks threaten the still-fragile recovery.
It’s understandable, then, that investors continue to price a stiff risk premium into the loan market. The S&P/LSTA Index, for instance, was bid at an average discounted spread of L+554 on May 4, implying an imputed default rate of 5.1%. That is 4.54 percentage points above the current reading, and it provides loan investors with a 2.4-percentage-point margin of safety over 2013’s average default rate expectation.
