Overview
The coming year will be a challenging one, but as this week’s Chart Room shows the current composition of the European leveraged loan market suggests that it is more strongly positioned now than it has been before previous crises.
Around 4 per cent of the European leveraged loan market currently comprises CCC-rated facilities (which lead to greater selling and spreads widening). Back in January 2007, before the Global Financial Crisis (GFC), around 10 per cent of the market was rated CCC, although since then the market has seen a fundamental shift to higher quality names as investors became more selective and the funding models of non-investment grade names evolved.
Already the current proportion of this triple-C rated debt is growing; the pace of downgrades in the Morningstar European Leveraged Loan Index (ELLI) has accelerated, with 18 reported in the three months to the end of October from 10 in the third quarter[1].
However, our bottom-up analysis of the market suggests that while downgrades will increase, the credit profile of the market will not weaken as much as it did in the GFC. In a hard landing scenario (which we believe is around 80 per cent likely to occur) the proportion of CCC debt will increase to around 10 per cent. In a more dramatic GFC-style scenario that assumes gas outages, extreme consumer stress, and limited fiscal or monetary support, the proportion of triple-Cs will increase to around 18 per cent.
By comparison, in March 2009 at the height of the GFC, the proportion of CCC-rated deals in the index reached 20 per cent.
Some frailties remain. The average rating of the market is lower than it was before the pandemic, while the proportion of deals rated B- or lower is higher than historic averages[2]. Similarly, while we do not expect the rate of defaults to reach the levels seen in the GFC, we do anticipate an increase in the coming year (albeit from a very low current level of less than 1 per cent).
However, current valuations suggest that lenders are covered for default levels well beyond anything ever experienced before in the asset class. Given how much pressure has already been priced into the market, even if the leveraged loan market saw losses in line with the worst ever period of defaults, investors may still see returns of around 8 per cent according to our internal analysis.
[1] European Weakest Links steady as stress signals persist, Pitchbook LCD, November 10 2022
[2] European Credit Outlook & Strategy 2023, J.P. Morgan, November 18 202
