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Convergence of Loan, High-Yield Bond Markets Sets Stage for Lower Recoveries in Next Downturn

August 20, 2018, 08:02 AM
Filed Under: Economic Commentary

Diminishing structural differences between high-yield bonds and leveraged loans will have negative consequences for investors in the next market downturn, Moody's Investors Service says in a new report. As demand for new loan issuance continues to outstrip supply, with the US syndicated leveraged loan market today topping $1 trillion, investors have increasingly relinquished control over debt structures and credit terms, contributing to the convergence of terms within the high-yield bond and loan markets and setting the stage for weaker recoveries when the current economic expansion ends.

"The combination of aggressive financial policies, deteriorating debt cushions, and a greater number of less creditworthy firms accessing the institutional loan market is creating credit risks that foreshadow an extended and meaningful default cycle once the current economic expansion ends," observed Christina Padgett, a Moody's senior vice president. "The result is more defaults than the last downturn as well as lower recoveries, undercutting a foundational premise for investing in loans."

In terms of size, the US syndicated leveraged loan market today rivals the high-yield bond market, buttressed by the expansion of collateralized loan obligations (CLOs) which now represent about 60% of the loan market. Because investors remain under pressure to meet fund mandates and increase yield, they continue to cede to borrowers' demands. Moody's cautions that such developments are also making it much more difficult for investors to be selective.

Borrowers with aggressive financial policies, particularly private equity-owned companies, have taken advantage of the convergence trends and accommodative credit markets since the advent of quantitative easing. Underscoring this more aggressive stance in financial policy is the deterioration in the distribution of US speculative-grade ratings. As reported by Moody's, the share of first-time debt issuers rated B3 reached a record 43% in the first half of 2018, and about 64% of US speculative-grade companies have a corporate family rating of B2 or lower.

According to Padgett, debt instrument ratings have also declined as loan-only structures have increased and debt cushions have eroded. Based on an analysis of Moody's loss given default assessments, the rating agency projects average first-lien term loan recoveries to decline to 61% going forward, against an historical average of 77% (1988 -- 2018), and with average recoveries for second-lien debt at approximately 14%, versus a 43% historical average.

Moody's Liquidity Stress Indicator is currently near a record low, and its B3 Negative and Lower Indicator is comfortably below its long-term average, allaying near-term concerns, while record-worst readings for the rating agency's bond and loan covenant quality indicators reflect the shift of power to borrowers. In view of the changing credit risk landscape, and to further facilitate differentiation, vigilance, transparency, and alignment, Moody's will be publishing a quarterly Credit Convergence Monitor, which will include key credit data points, including loan and bond covenant quality scores, to help highlight the impact of risk-taking by speculative-grade borrowers in the leveraged finance markets, as well as the markets' vulnerabilities.

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