European weak links decline as crisis has yet to impact credit risk
While the crisis caused by the Russian-Ukrainian conflict has been felt in global markets, including in the European area of leveraged finance, its impact on credit risk is not yet clear, according to the LCD data.
Looking at some of the leading indicators, delinquencies for the S&P European Leveraged Loan Index (ELLI), which is usually a lagging measure, rose only slightly through the end of February. Meanwhile, credits’ ranks in the ‘weakest link’ category of European LCD lending continued to thin in the last quarter of 2021, falling to 5.35% of publicly rated issuers in the index after a pandemic-era peak of 17.3% in the second quarter of 2020 – although of course this reading predates the current geopolitical crisis.
Weak links are defined as issuers rated B- or lower by S&P Global Ratings, with a negative credit outlook or on negative watch. While the COVID-19 pandemic has led to an increase in the number of weak links in Europe, the percentage of these credits has continued to decline steadily since the pandemic closed global markets in spring 2020 and at the end of the last quarter of 2021. was approaching its pre-pandemic level. However, the real impact of the Russian-Ukrainian conflict on this measure remains to be seen.
By the second quarter of 2021 – a year after the number of weak links peaked at 43 out of a total of 249 publicly rated credits (representing 17.3% of the ELLI) – the number of such credits had fallen to 26 (9 .71%), and by the end of the fourth quarter of 2021, this share had fallen further to just 16 of the 299 publicly rated issuers (5.35%). Thus, the level of weak links is approaching its pre-pandemic share of 10 publicly rated issuers out of 227 (4.4%), observed at the end of 2019.
Looking closer at the data, 62.5% of current outstanding European weak links earned this designation in 2020, while 18.8% entered the category in 2019. No credit entered the cohort in 2021 through Q4 – when 12.5% was added to the Weakest Links category – while only 6.3% of the group entered it in 2018.
By quarter, the highest percentage of weak links in Q4 2021 entered the category in Q2 2020 (at 25%), with the second highest share measured in Q1 and Q4 2020 (both at 18, 8%) .
The universe of weak links shrinks when more loans leave the cohort – either due to default, upgraded ratings, improved outlook, or de-rated – than from them. to rejoin. In the fourth quarter, all credits exiting the category were revised to a stable outlook. For example, S&P Global Ratings reviewed the cruise ship operator Hurtigruten Group to stable from a negative outlook after a shareholder injection, noting that “the group’s improved liquidity position should allow it to navigate the full reopening of its cruise operations and retain sufficient headroom in case of further setbacks resulting from the continuing effects of the COVID-19 pandemic.
Improved results also helped some of these credits. UK based holiday park operator Richmond UK Holdco Ltd. trading under the brand name Parkdean Resorts, was upgraded to B- with a stable outlook, for example. According to S&P Global Ratings, “the company reported strong results for the third quarter (Q3) of 2021 driven by increased stay trends and management effectiveness metrics.”
The two new entrants to the cohort were BVI Holdings Mayfair and Knowlton Development Corporation. BVI was downgraded to ‘CCC+’ after it ‘announced significantly weaker than expected results for the third quarter ended September 30, 2021, primarily due to operational headwinds and high business development costs and other non-current charges. essential,” according to S&P Global Ratings. . Knowlton Development Corp. was assigned a B- rating with a negative outlook, according to the rating agency that “the risks associated with KDC’s higher leverage, combined with potential execution errors or under- performance in an inflationary environment, could keep leverage high over the next 12 months.
Faults are stable when the secondary reacts
The impact of the Russian-Ukrainian conflict on credit risk is not yet apparent in terms of defaults in the ELLI, with this measure increasing only slightly to 1.26% by number of issuers at end-February on a basis of 12 months in arrears, and 0.82%% based on the principal amount. Both of these measures are up slightly from January, when they were 0.95% and 0.62% respectively. These readings compare to pandemic-era highs of 4.84% and 2.61%, respectively – both set in October 2020.
Secondary loan and bond markets were the first to react to the geopolitical crisis, with the ELLI’s weighted average bid falling to 96.53 on March 8, marking the lowest bid for the index since November. 2020. For reference, this metric has fallen to 78.92. on March 24, 2020, after the COVID-19 pandemic shook global markets (its lowest level since September 2009), and in mid-January this year it climbed to 99.02, surpassing the high of 2021 of 98.92. The last time the index topped 99 was in November 2018, and sources told LCD that much of the gain in the opening phase of 2022 came from buyers looking for any source. of value among the remaining discount names exposed to COVID-19.
European loans posted a negative monthly return for the first time in nearly two years in February, with the ELLI posting a negative return of 1.11% (excluding currencies) during the month as markets reacted to the Russian invasion of Ukraine. This negative return ended a 22-month positive streak, while February’s performance also made the ELLI’s cumulative return negative, at -0.76%.
On February 24 – the day Russian forces began their invasion of Ukraine – the ELLI posted a negative return of 0.44%, its lowest daily return since June 2020, when it fell to 0 .47%. This is the third lowest return since April 2020, after the start of the markets disrupted by COVID-19.
Meanwhile, the percentage of credits in the ELLI that are in trouble – or those priced below 80 – rose slightly to 0.66% in February, from 0.36% in January and 0.30% in December. This percentage declined throughout 2021, after increasing to 0.93% a year earlier, and showed a dramatic improvement from the 29% of installs priced below 80 recorded at the end of March 2020.
Coming back to fundamental credit risk, the ELLI has seen steady credit improvement since the start of the pandemic. Just a year ago, there were six upgrades through the end of February (on a rolling three-month basis), with 14 downgrades in the same period, compared to 9 upgrades at the end of February 2022 and 5 downgrades.
Indeed, the downgrade-to-upgrade ratio (based on facility-level ratings) fell from an all-time high of 56x in April 2020 to its lowest level in two years (despite being at the level of the August 2021 reading), at 0.56x at the end of February (over three rolling months).
In addition to improved credits in terms of upgrades, the share of credits in the triple-C category of the ELLI has decreased since 2020, from 8.53% in December of the same year, to 5.17% at the end of 2021, decreasing further slightly to 4.82% at the end of February this year. Single-B minus credits also decreased their share of the index over the same period, from 22.67% at the end of 2020 to 19.53% at the end of 2021, and 19.26% at the end of February.
Although the number of weak links has decreased in both absolute and percentage terms since the early days of the pandemic, the share of credits in the triple-C rating category has increased (at the end of 2021, before the crisis current geopolitics). At the end of the fourth quarter of 2021, 62.5% of Weak Links were classified as triple-C, double-C or single-C compared to 37.5% as B-. This compares to 25 (for a 58% share) in the B- rating category at the end of the second quarter of 2020, while 18 (42%) were in the triple-C, double-C or simple-C.
Looking at the data by industry, the Entertainment & Leisure, Services & Rentals, and Games & Hotels segments represent the largest shares of weak links in the ELLI. Although these sectors were part of the cohort observed in the fourth quarter of 2020 – as well as during the initial pandemic peak – there was then a much wider distribution of sectors affected, including automotive, chemicals, IT and l electronics, manufacturing and machinery, telecommunications. , and Television.
But all of these quarters contrast with the pre-pandemic period, when far fewer sectors were present in terms of this analysis, with no companies in the consumer non-durables, entertainment and leisure, services and rental or services sectors. games and hotels only appear in the weakest links. .
LCD first published its European Weak Links Analysis after the second quarter of 2021.