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Distressed leveraged finance ratios hit 2011 high

Investors face increasing risks from defaulting borrowers of leveraged loans and high-yield bonds, as these could significantly impact banks, the European Banking Authority (EBA) has said in a note.

The EBA defines a ‘leveraged loan’ as, for example, high indebtedness of the borrower, a credit rating below investment grade or a high loan spread at issuance.

Recently, the S&P European Leveraged Loan Index (ELLI) distress ratio, which measures the percentage of loans in the index trading below 80, as well as the European high-yield bond distress ratio have risen to levels not seen since 2011 (see charts below).

Since the global financial crisis, leveraged finance has approximately doubled in size in both the US and the EU. This has been coupled with increasing borrower indebtedness and weakening credit and lender protection over the past few years, EBA said.

Highly accommodative monetary policy and the search for yield have fostered the growth of this market.

Global banks (mainly Japanese and US based) remain exposed to over half of the overall market, with exposures mostly in the form of retained revolving credit facilities and investment in highly-rated collateralised loan obligations (CLO) tranches (see graph below).

Leveraged loans

EBA said that default rates of loans have not shown strong signs of deterioration until very recently.

This could indicate that the lack of maintenance covenants might be delaying default recognition.

The paper also suggested that it could be due to the maturity profile of outstanding loans. Citing S&P data, EBA said that the increase in defaults might be limited as relatively few loans mature from 2019 to 2021 (see graph).

Also, the ELLI price declines, as of end-March 2020, might mean that the market is already pricing in a sharp increase in default rates.

High-yield bonds

The recent rise of distressed ratios of high-yield bonds is reflected in the current price.

“Even after some recovery in the last days of March, during the first quarter of 2020 high-yield bond spreads widened by more than 400 basis points. The widening was even higher for US high-yield bonds, arguably because of a higher proportion of oil and gas companies in the US index,” the report writes.

EBA warns however that high-yield bond indices might not reflect the actual deterioration of the market.

The reason is that investment-grade corporate bonds that fall into the high-yield category as a consequence of rating downgrades (fallen angels) are incorporated and default issuances are taken out.

Risks

EBA concluded that “as covid-19 and economic lockdown impair leveraged borrowers’ capacities to repay their debts, some banks might be significantly affected, not only through their direct exposures but also via second-round and spillover effects”.

The bulk of these exposures is in the form of leveraged loans, while banks hold comparatively small amounts of high-yield bonds and CLOs.

In relation to liquidity risk, banks may face material drawdowns on the revolving credit facilities granted to leveraged borrowers.

In this study, EBA aggregated data on leveraged finance from 31 large EU/EEA banks. It reveals an outstanding exposure to leveraged finance of more than €500bn (€400bn without UK banks), as of June 2019.

The paper, however, also pointed to significant gaps in data availability.

Elena Johansson

Senior Reporter

Part of the Bonhill Group.