By the Numbers

Rising rates should test sectors of the loan market

| June 3, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Corporate leverage has kept rising for years. But corporate loan performance has remained solid thanks in part to easy monetary policy. As the Fed girds for inflation, the next chapter of the credit book may be different. As rates rise, growth slows and companies’ earnings outlook changes, credit performance should diverge across borrowers in the leveraged loan market. The deviation would be most palpable in the ratios of debt-to-EBITDA and EBITDA-to-interest expense. By those measures, not all industry exposures are equal.

Based on the trailing 12-month data from S&P, debt-to-EBITDA in new loans across different industries mainly ranged between 4.5x to 6.0x while EBITDA-to-interest-expense ranged between 3.8x to 4.5x (Exhibit 1). Television, cable and environmental are outliers in terms of leverage and interest coverage. It is worth noting that the average interest coverage for highly leveraged loans in the first quarter of 2022 is already below many industries’ trailing 12-month average.

Exhibit 1: Issuers of leveraged loans vary widely in, well, leverage

The leverage and interest coverage ratios are trailing twelve-month average of primary market issuance as of April 2022.  The Q1 2022 average is for highly leveraged loans with spread at SOFR +225 and higher.
Source: Amherst Pierpont Securities, S&P LCD

CLO and broad investor exposure to these industries varies substantially across the $1.35 trillion loan market with services, high tech and healthcare the largest exposures (Exhibit 2). Among these three, high tech has the most leverage followed by services and then healthcare.  Among the next three exposures, media has the highest leverage of any large exposure with chemicals next and manufacturing slightly more leveraged than healthcare.

Exhibit 2: The US leveraged loan market has exposure across industries

Amount outstanding refers to secondary market first-lien outstandings as of April 2022.
Source: Amherst Pierpont Securities, S&P LCD

The credit spread widening this year has contributed to the rising cost of debt, but an aggressive Fed rate hike plan would further squeeze the interest coverage ratio across all loans to a new low without companies’ earnings growth support.

In a hypothetical scenario where SOFR rises in the next year by 150 bp while EBITDA and loan credit spread stay at their recent trailing 12-month levels, the EBITDA to interest coverage ratio of most industry sectors will drop to 2.5x to 3.0x—quite low by historic standards (Exhibit 3).

Exhibit 3: A 150 bp rise in SOFR would cut interest coverage around 30%

Assume current 3-month SOFR at 1.43%.  The average institutional loan credit spreads in trailing twelve months as of April 2022 are used to calculate interest expense.
Source: Amherst Pierpont Securities, S&P LCD

Take healthcare, for example, where the trailing 12-month average EBITDA on new loans as of April was $657.4 million.  The total debt-to-EBITDA and EBITDA-to-interest were at 5.4x and 4.5x, respectively.  With a 150 bp rise in SOFR, the EBITDA-to-interest ratio will drop to 2.7x (Exhibit 4)

Exhibit 4: A 150 bp rise in SOFR would reduce Interest coverage in healthcare

Source: Amherst Pierpont Securities, S&P LCD

S&P recently reported an EBITDA growth of 15% year-over-year in the first quarter for 160 public filers in the leveraged loan index, but this represents only 13% of the total index.   With the broad equity market index down 14% year-to-date, it is optimistic to assume corporate earnings will stay at current levels.  The quarter-over-quarter changes may paint a better picture of recent trends.  For example, the average EBITDA from the public filers in the healthcare sector in the leveraged loan index had two consecutive quarter-over-quarter declines: -5% in the last quarter of 2021 and -8% in the first quarter of 2022.  The average first quarter EBITDA from the public filers in the tech sector also reported a 5% decline. The negative EBITDA trend implies higher leverage on existing debt, potentially impeding efforts to raise new debt.

Rising interest rates should put significant pressure on leveraged balance sheets, raising the risk of downgrade if not default. Earnings, balance sheet liquidity and debt maturities will all play a big part, too. But the leveraged loan market, largely funded with floating-rate debt, will be a bellwether of corporate financial health as the Fed fights inflation. Not far behind will be the performance of CLOs as the main holders of that risk.

Caroline Chen
caroline.chen@santander.us
1 (646) 776-7809

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