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Let’s get the bad news out of the way: faced with higher interest rates and lower income, more companies in the European leveraged loan universe are going to default on their debt. But as this week’s Chart Room shows, investors in the market have historically seen excess spreads that more than compensate them for losses due to defaults. Past performance is of course no indication of future returns. But it can give us a flavour of what is to come, and our internal analysis suggests that those spreads should stay positive even if defaults hit the highest levels currently being predicted.
Some background is helpful. Since December 2004, the median difference between the discount margin of the Western European Leveraged Loan Index (WELLI), a common benchmark for the sector, and the loss rate (the default rate adjusted for recoveries) has been 414 basis points. Historically, this discount margin has widened 8 to 12 months before any increases in the loss rate, and as of the end of August it stood at 534 basis points over Euribor before expected losses, suggesting it is already pricing in any future defaults. (At the end of August, the last-twelve-month loss rate in the index stood at just 91 basis points).
To put it another way, investors’ returns in this space have been well insulated, with an average buffer of more than 4 per cent above losses for almost two decades (a period that has included the global financial crisis, the European sovereign debt crisis, and the pandemic), and that buffer tends to widen pre-emptively in anticipation of defaults.
Based on our current projections, we expect excess spreads to stay ahead of defaults. Rating agency Fitch is currently forecasting a 4 per cent default rate to the end of 2024 in their base scenario. Should this come to pass, our analysis suggests that the Western European Loan Index should still return an excess spread of 374 basis points over three-month Euribor (based on a recovery rate of 60 per cent).
Even under Fitch’s most pessimistic scenario, where default rates could hit 6 per cent, our calculations suggest the WELLI could still see excess spreads of 290 basis points over Euribor.
Looking back at the past two decades, the tightest excess spread recorded since the beginning of our analysis period in 2004 was 138 basis points over cash in June 2009. Default rates would have to rise to 9.9 per cent (based on a 60 per cent recovery level) before we reached that level of historical tightness. So far, the highest default rate seen in the WELLI since 2004 was 8.5 per cent in February 2013 (and defaults peaked at 6.8 per cent in the wake of the global financial crisis in December 2009).
All investment involves risks, and no returns are bullet proof. And indeed, rising defaults and increasing losses are never going to be welcome news for investors. But with excess spreads comfortably above risk-free rates—and priced to stay that way, based on projected default rates— Europe’s leveraged loan market looks to be relatively well insulated.