February 26, 2019

How Smaller Debt Cushions Are Impacting the Market

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As leveraged loans become more prolific, debt cushions are shrinking and posing a risk to certain lenders. This is the ideal time to evaluate and adjust portfolios for risk and return. 

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Debt cushions have begun to shrink, and this is impacting the safety of leveraged loans. The overall volume of leveraged loan issuance in 2018 was $622 billion, according to LCD. This was the second-highest volume on record, just behind the $650 billion issued the prior year. As more of these loans flood the market, what has become more startling is their dominance relative to other loan asset classes.

More companies are issuing leveraged loans that are unprotected by junior debt. 

The Growing Dominance of First-Lien Loans

More companies that are considered credit-challenged are favoring loans that would be repaid first in bankruptcy, or first-lien loans. LCD reports that 27% of first-lien loans at the end of 2018 were backed by companies that didn't have outstanding junior debt. This was up from 26% in 2017 and 18% in 2007 just before the last financial crisis. 

When more junior debt exists, this is referred to as a "debt cushion" for first-lien loan investors. In a bankruptcy, senior lenders will typically get most of their money back, and junior bonds and loans will absorb losses first. 

Assuming a company files for bankruptcy with $10 billion of unsecured bonds and $15 billion in first-lien loans, which were determined to be worth $15 billion total, the bondholders would get nothing, and the loan holders would fully recover their money. 

But if that same company had no bonds and $20 billion in loans, investors would receive just 75 cents on the dollar. 

Smaller debt cushions mean that banks should consider adjusting portfolios. 

Smaller Debt Cushions Impact Recoveries During Default

Having an overabundance of first-lien loans isn't as positive as it seems on the surface. Even Moody's has warned investors that they are likely to recover substantially less in bankruptcies than they have in the past because of the overuse of leveraged loans. As borrowers increasingly tap this market, lenders find that there is no one behind them to cushion the blow. 

LCD reports that the share of borrowers with a first-lien only structure hit a 10-year high in 2018, at 64%. This was up from 59% the prior year which was similar to the rate in 2007 (60%), just before the start of the Great Recession. 

LCD concludes that, based on the results of its recent recovery study, a bigger debt cushion is going to result in larger recoveries for debtholders in the event of a default. For example, when there is a substantial debt cushion (75% or greater), the discounted recovery was 94% on average. When the debt cushion drops to a range of 26% to 50%, the discounted recovery was 73% on average. 

Who is Using Leveraged Loans?

It might seem like only no-name, small businesses, and startups are using this type of debt, but this isn't the case. In June, online ticket seller Vivid Seats added $115 million in funding to its existing first-lien loan, in large part to pay down a second-lien loan. 

While not quite the same thing, junk bonds are increasingly fueling some of the world's most popular companies including Dell Technologies Inc., Uber Technologies Inc., and Telsa Inc. The Wall Street Journal reports that the momentum of leveraged loans waned at the end of 2018, but picked up again in the past month as companies return to the market to issue new debt.

As leveraged loans become more prolific, these pose a growing risk to lenders. In a shifting market, it makes sense to evaluate business in terms of risk and return. Garnet can help banks and others adjust their portfolios appropriately.

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