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Leveraged Loans

European leveraged loan Weakest Links count falls in Q4, though defaults send mixed signals

Many European loan borrowers have been able to reduce costs through recent repricings, but sustained higher interest rates have put operational pressure on the balance sheets of more-challenged companies.

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The share of at-risk issuers designated “Weakest Links” in the European leveraged loan market fell slightly in the final quarter of 2023, but remains elevated. Although many borrowers have been able to reduce costs through recent repricings, sustained higher interest rates have put operational pressure on the balance sheets of more-challenged companies, and some of these credits now face rising leverage and liquidity issues.

A forward indicator for potential future default activity, LCD’s Weakest Links metric tracks companies rated B-minus or lower (excluding defaulted deals) by S&P Global Ratings that have a negative outlook or implication, and are therefore on the cusp of a downgrade to the vulnerable triple-C category.

With a tally of 21 issuers at the end of the fourth quarter, the Weakest Links cohort represented a 6.4% share of the overall European loan market. This is down from 7.6% in the third quarter, when the share of Weakest Links had jumped by just over 50% from the previous year — however, the rolling 3-month average shows a steady increase since the third quarter of 2022.

This analysis is based on credits in the Morningstar European Leveraged Loan Index (ELLI). If a credit exits the ELLI it remains in the Weakest Links category until its rating is withdrawn or it defaults, or the issuer nets an upgrade or improvement in the outlook on its corporate credit rating. The category would therefore only shrink when more loans exit this cohort — either due to a default, a ratings upgrade, an improvement in outlook or a ratings withdrawal — than join it.

Operational challenges
Credits that joined the cohort in the fourth quarter are facing operational challenges, weakening liquidity and elevated leverage. Taking the example of Advancion Holdings LLC (doing business as Advancion Corp. and formerly known as Angus Chemical Co.), S&P Global Ratings revised its outlook to negative from stable following “declining demand and weakened operating results through the first half of 2023 and our expectation for elevated debt leverage in 2023.” The rating agency added that: “Macroeconomic uncertainty, sluggish demand, and customer destocking continue to affect the company.”

Similarly, the operating performance of Germany-based methyl methacrylate (MMA/PMMA) producer Röhm remains weak due to depressed production volumes and prices, according to S&P, which said: “The negative outlook reflects minimal rating headroom due to weakening liquidity, elevated leverage, and our expectation that Röhm will still report negative free operating cash flow (FOCF) in 2024.”

Meanwhile, credits exiting LCD's Weakest Links cohort (via outlooks changing to stable or positive, from negative) appeared to benefit from recapitalization exercises coupled with better growth stories. For example, the parent of property and online household services group ZPG, Zephyr Midco 2 Ltd., launched a process to extend its debt maturities by three years to 2028, along with a £110 million common equity injection from shareholders, according to S&P. The transaction followed “ZPG's improving operating performance, with strong organic revenue and earnings growth over the first half of 2023 and sound prospects over the next 12-24 months,” the ratings agency said.

Likewise with Biscuit Holding, S&P said the borrower's “revenue and profitability strongly rebounded in 2023 compared with the very weak levels in 2022. This is thanks to price increases to offset past high operating cost inflation, which compensated for some volume loss.” In addition, the agency noted the firm's “liquidity position has improved thanks to much higher EBITDA generation, increased use of factoring programs, a cash injection via senior debt issuance from the sponsor, and some sale and leaseback transactions.”

Default level
Among the companies designated Weakest Links in LCD’s analysis, 14% defaulted in the fourth quarter — which is above the 13% average for this measure over the past three years (LCD first published its European analysis of Weakest Links after the second quarter of 2021), but lower than the third quarter of 2023, when it stood at 17%. The highest share of Weakest Links to default — at 19% — was recorded in the fourth quarter of 2021, and again in Q4 2022.

Meanwhile, the ELLI default rate increased to 1.62% by principal amount in December, and then grew to 1.86% in January — the highest it has been since March 2021.

Entry point
Regarding when credits became Weakest Links, 52% joined the cohort in the second half of 2023. What's more, the third and fourth quarters featured the highest shares of entrants by quarter since the beginning of 2021 — at 29% for Q3 2023, and 24% for the final quarter.


Although the number of Weakest Links remains high, the share of credits in the triple-C rating segments was lower in the second half of 2023, compared to the opening quarters of that year.

At the end of 4Q 2023, 57% of the Weakest Links were in the triple-C, double-C or single-C rating buckets, while in Q3 2023 this figure was even lower, at 52%. These two quarters compare with chunkier shares at 70% of Weakest Links across the C-rating buckets in the second quarter, and 68% in the first quarter of 2023 — suggesting agency activity targeted companies moving to B-minus (negative) ratings at a faster clip than downgrades to the C-rated bracket.

Sector watch
Breaking down the analysis by sector, the Computers & Electronics segment (LCD’s designation for the Technology sector) and Entertainment & Leisure were the fourth quarter's largest contributors to the Weakest Links cohort, with four companies each. The Healthcare and Chemicals segments were the runners up, at three credits apiece.

Back to the future
Another forward measure shows a slight improvement in the fundamental picture versus the previous quarter, with the ELLI distress ratio — a keenly watched indicator of future default activity, defined as loans priced below 80 — dropping to 3.96% at the end of December, from 4.26% at the end of November. Since then, the measure has fallen further, to 2.80% in January.

Meanwhile, downgrades outpaced upgrades at the end of the fourth quarter for a sixteenth-consecutive reading, at a ratio of 3.5x in the three-month period ending Dec. 31. In January, this measure increased to 7.67x, the highest it has been since September 2020 (for reference, it stood at 1.36x at the end of the third quarter).

S&P Global Ratings is expecting additional credit deterioration in 2024, according to its Global Credit Outlook, published Dec. 4. The rating agency specifically said this would likely be centered at the lower end of the ratings scale, where close to 40% of credits are at risk of downgrades. According to the report, sectors exposed to a decline in consumer spending are the most vulnerable.

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