Facing a potential recession and a prolonged higher-interest-rate environment, the
SRS Acquiom Loan Agency team explores macroeconomic conditions and their effects on the leveraged loan market in the coming year.
Amid weaker market conditions and rising interest rates, demand for leveraged loans has declined. Ratings of debt by companies that obtained loans during the record-setting prime of 2021 are being placed on negative watch and even downgraded, with some edging into distressed territory. What does this mean for deal parties?
Liquid markets enabled record M&A activity in 2021, which drove up purchase-price multiples as well as leverage multiples. Appetite for investors to hold risky debt in addition to the ultralow interest-rate environment contributed to weakened lender protections in credit agreements. Against the choppier backdrop, stress measurements are rising, and these very loans are at risk of downgrade.
Companies with negative-ratings outlooks are vulnerable to recessionary pressures, sustained inflation, and other macroeconomic blows from the economy. Loans become distressed when uncertainty emerges about a borrower’s ability to make its payments according to the terms of the credit agreement.
The Fed Factor
The Federal Reserve board of governors voted to raise rates on February 1 by .25 percentage points, to 4.5-4.75%, the highest level since 2007. At its December meeting, the Fed indicated that rates likely need to go higher and will remain elevated until “some time in 2024,” according to its Dec. 14 announcement. The Fed also updated its inflation projections and stated that “more evidence” was needed that inflation would soon decelerate. Floating rates, which made loans an attractive asset class to investors in a rising interest-rate environment now require highly leveraged companies to allocate more cash flow to debt service.
All of these factors weigh on business investment and growth. Companies may need to deleverage to avoid a default, while a recession may also slow their ability to pay down debt. Companies with a high total debt-to-earnings ratio will suffer in a recession, with a hit to their profit margins, increasing the likelihood of distressed exchanges and missed interest payments. Recovery rates may also suffer from a recession, with creditors recouping significantly less than face value if their loan should default.
For now, deals are getting done. Although banks are increasingly reluctant to lend because of economic uncertainty, private credit has emerged as an alternate source of financing for leveraged buyouts. Private credit, or direct lending, refers to financing provided by non-bank firms such as business-development companies (BDCs) or private funds. A majority of leveraged buyout (LBO) activity in the fourth quarter relied on such financings, according to Pitchbook LCD.
Doomed to Default?
Against the current economic backdrop, ratings agencies and banks alike have adjusted their default projections. By the end of 2023, Fitch Ratings is forecasting a default rate between 2 to 3%, and 3 to 4% in 2024 compared to Fitch’s default forecast of 1.6% at the end of 2022. Fitch cites demand erosion, inflation, and supply-chain disruption as key factors.
Recovery rates on defaulted debts may be lower given the prevalence of the covenant-lite feature of many loans. With covenant-lite, the ability for a lender to reprice loans to reflect increased risk is less likely. In previous downturn cycles, loan pricing would increase in exchange for covenant relief, but fewer deals now contain robust lender protections.
CLO Woes
Higher borrowing costs and ratings downgrades may affect the collateralized loan obligation (CLO) market, as well. CLO portfolios are subject to various restrictions, one of which is limitation on holdings of CCC-rated assets, often set at 7.5%. Currently CCC-rated holdings average about 5%. Continuation of the recent wave of ratings downgrades could cause issuers to exceed the CCC threshold. Bank of America analysts foresee CCC buckets to increase to 8 to 10% and possibly as high as 15% in a “severe stress scenario.” When the CCC threshold is breached, cash distributions due to investors holding the riskiest CLO tranches (CCC), referred to as “equity investors,” are redirected to investors higher up in the CLO capital structure.
In addition to managing credit risk in a weakening economy, the combination of rising rates and ratings downgrades further complicates portfolio-management decisions. If ratings downgrades cause the CLO’s minimum weighted average credit-rating test to be violated, changes to the portfolio composition are required to improve the credit-rating test. This requirement would motivate portfolio managers to sell lower-rated loans and seek higher-rated, lower yielding loans. This in turn may exert pressure on the CLO’s minimum-interest coverage test.
Investor demand for CLOs has diminished in recent months owing to a widely anticipated recession and the prospect of increased default rates. CLO liability costs have risen over the past year, narrowing expected returns earned on the difference between the income generated on loan assets and the cost of funding the CLO portfolio. In addition to limiting new CLO issuance, these market dynamics may limit managers’ ability to refinance and/or restructure existing deals exiting a non-call or reinvestment period. Barclays estimates that 90% of existing CLOs will move beyond their non-call dates by the end of this year.
Silver Lining?
Amid the low-interest-rate environment of preceding years, many borrowers were able to refinance debt, extend maturities, and reduce their cost of capital. The lack of near-term maturities will help keep default rates suppressed. In fact, not all sources are factoring in a recession. Morgan Stanley forecasts the U.S. will avoid recession, while Barclays sees only a “mild” recession beginning in the second quarter.
Strength of the job market, aside from the tech sector, is another positive for now. If jobs data remains healthy, revenues should not fall as much as usual during a downturn.
