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Leveraged Loans: “Weakest Links” Portend Uptick in Default Rate

Despite the strength of the credit markets, institutional investors are always on the lookout for indicators of market health. To that end, LCD is pleased to introduce for the loan market “Weakest Links” analysis, a barometer we’ve adopted from associates S&P Global Fixed Income Research ($$).

Weakest links are loan issuers rated B– or lower (excluding defaults) by S&P Global with a negative outlook or implication.

At the end of 2Q17, that measurement is 6.4% for the S&P/LSTA Leveraged Loan Index, up sharply from 4.4% at the end of 2015 but down from 7.7% at the end of 2016.

weakest link share of market

The trend holds if we exclude the troubled Oil & Gas industry from the past 18 months. The share of weakest links excluding O&G is 5.5% currently, higher than the 4% reading from 18 months ago but lower than the 6.3% level at the start of 2017.

The hump-shaped pattern over the past 18 months mimics the default rate over the same time. Currently, the default rate based on issuer count is 1.3% (down from 1.49% last month). This is up from the 1.1% seen 18 months ago but down from 2.1% at the start of 2017.

Where are they now?
Just how weak are the weakest links? Over time, how do they perform? To address these questions we look back 18 months, to the year-end 2015 weakest links, and assess their status today.

At the end of 2015, the Index’s weakest links consisted of 42 issuers with $37 billion of par outstanding. Eighteen months later, it seems that they really were the weakest links: 40% of those issuers have defaulted, 31% remain weakest links, 19% have improved out of the weakest links category, and 10% have withdrawn their ratings (half of those were due to positive changes; the other half withdrew their ratings after a subsequent downgrade).

Despite the fact that O&G was in the midst of its crisis 18 months ago, excluding O&G does little to change the analysis. Without O&G, the year-end 2015 weakest links comprised 36 issuers with $32 billion of par outstanding. Eighteen months later, 36% of those issuers have defaulted, 36% remain weakest links, 19% have upgraded, and 8% have withdrawn their rating.

As would be expected, the default rate for the weakest links is significantly higher than for the broader market.

Looking at the 2015 year-end population, the default rate for issuers rated B or higher is 0.4%, as only three out of those 771 issuers defaulted over the following 18-month period. For those issuers rated B– or lower with a positive or stable outlook, the default rate rises nearly 18x, to 7%, as six of those 86 issuers defaulted. And among the weakest links, the default rate increases again nearly 6x, to 40%, as 17 out of 42 issuers defaulted.

weak links 3

The market’s bull run over the past 18 months has significantly changed the risk/reward analysis on the weakest links. At the end of 2015 the average bid for weakest links was 68.50, 25% below the average bid of 92.46 for the broad Index. The demand for paper that has driven this bull market over the past 18 months has driven the average bid for the weakest links up nearly 20 points, to 87.07, just 11% below the average bid of 97.51 for the broad Index.

weak links 4

Hopefully, the recent swing in favor of supply over demand will help deflate the secondary market. The future uptick in default rates is inevitable, as evidenced by the rise in the percentage of weakest links versus year-end 2015. Including the issuers already in default, if we assume that 36% of the current weakest links default in the coming 18 months, that would push the default rate based on issuers up to about 3.8%, well above the rates seen during the O&G default peak in 2016. — Ruth Yang

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This story first appeared on www.lcdcomps.com, an offering of S&P Global Market Intelligence. LCD’s subscription site offers complete news, analysis and data covering the global leveraged loan and high yield bond markets. You can learn more about LCD here.

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