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U.S. Leveraged Finance Faces Higher Default Rates and Mounting Downgrade Pressure in 2020

Date: Dec 27, 2019 @ 09:00 AM
Filed Under: Industry News

Fitch Ratings expects the U.S. institutional leveraged loan default rate to climb to 3% in 2020, while the 2020 high yield default rate is expected to reach 3.5%, according to a new Fitch Ratings report.

"Growing outstanding amounts on our Lists of Concern, net downgrade pressure and increased investor skepticism toward lower-rated and aggressive sponsor deals defined second-half 2019," said Michael Paladino, Managing Director and Head of U.S. Leveraged Finance. "These themes are likely to shape 2020 trends. While growing pockets of concern led us to revise our default rate forecasts higher, economic fundamentals and market access remain modestly constructive for leveraged U.S. corporates."

Ongoing weakness and lack of market access in the lowest rated-tier of the energy sector is expected to remain a theme in 2020, leading to 13% and 7% sector default rates on loans and bonds, respectively. Retail and energy remain a concern, while lower-rated pockets of healthcare/pharmaceuticals and technology present growing risks.

Years of robust loan demand helped fund a wave of debt-funded M&A, LBOs and dividend recapitalizations that increased leverage and gradually weakened the rating mix of speculative-grade issuers. Lower interest rates have reduced demand for floating rate loans, but are broadly supportive to the speculative-grade credit market. U.S. debt is likely to remain attractive on a relative basis, absent an economic shock.

Most of the rating migration is the result of sponsored transactions with highly levered capital structures at inception that often rely on aggressive EBITDA assumptions given this point in the cycle. Weaker documentation presents additional risk and is likely lead to a greater divergence in recovery outcomes when the cycle turns.

Investors are showing a notable preference for 'BB' rated loans over 'B' and lower issues, as sponsored transactions generate more push-back and CLO managers seek to limit potential exposure to 'CCC' credits in the event of further downgrades, creating pressure on secondary market trading levels.

Default rates are forecast to rise to 3% for U.S. institutional leveraged loans in 2020 based on Fitch’s bottom-up forecast. And growing concentration of ‘B–’ credits poses downgrade risk, but CLOs have ample ‘CCC’ cushions.

"We expect to see more price volatility and a higher default rate for leveraged loans moderated by CLOs’ limited exposure to troubled sectors and weak counterparties. U.S. CLO issuance is expected to be solid but down on 2019. CLO managers will continue to consider rate transition plans in 2020, as we move closer to when LIBOR will become unsupported."

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