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As leveraged loans gobble up market share, all-important debt cushion grows thin

debt cushion

Two straight years of unprecedented leveraged loan issuance by U.S. corporations and private equity shops – often at the expense of the fixed-rate high yield bond market – has whittled away the subordinated debt tier that can buoy recoveries for investors in cases of default.

Indeed, in 2018, a staggering 79% of U.S. speculative-grade debt issuers last year obtained financing solely from the reliably accommodating syndicated loan market (as opposed to structuring a deal with both loans and bonds). That’s the highest reading since LCD began tracking this data in 2007, and is up from 70% in 2017.

With the recent activity, the share of the currently outstanding leveraged loan universe – $1.15 trillion – comprising a loan-only structure has grown to a record 27%, according to LCD. This evaporation of the subordinated debt cushion matters.

As LCD detailed in its recent recovery study, the bigger the debt cushion in a deal’s capital structure, the better the recoveries for debtholders in cases of default (the cushion is calculated as the share of total debt that is subordinated to the instrument being assessed).

For example, for loans with a very substantial debt cushion (more than 75%), the average discounted recovery was 94%, according to LCD’s analysis of data tracked by LossStats. The lower the cushion, the lower the recovery. A cushion of 26–50% resulted in an average recovery of 73%, for instance.

Of course, recoveries and leveraged loans have been topics of considerable interest lately as loosely structured covenant-lite issuance has taken full root in the loan market, and amid signs that an already aged credit cycle might be coming nearer to an end.

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