Large Bank Supervision Forum 2023

September 2022

Senior Loans for Community Banks

Default risk from higher borrowing costs appears manageable Rapidly rising short-term rates should, all other things being equal, increase borrowing costs for senior loan issuers. Therefore, an aggressive rate-hike cycle could pressure interest coverage ratios, particularly if earnings begin to degrade in a recessionary environment. While this risk has risen, we believe company earnings, cash flow generation and liquidity appear reasonably supportive overall for the loan market, and particularly for the BB cohort. As it stands today, default risk is rising slowly but remains very low, with default rates of just 0.6%, compared with a long-term average of just under 3.0%. 1 Moreover, defaults within the BB cohort, which represents bank-appropriate risk, have been consistently much lower than within the broader loan market (Figure 4). Only 2009 (the global financial crisis) and 2020 (the pandemic) stand out for their notably higher default rates. On a cumulative basis over the past 10 years, loans originally rated BB accounted for just 12% of all loan defaults (by issuer count). Figure 4: BB rated loans have had minimal defaults in most years Total defaults of loans rated BB compared to the broad loan market

Originally BB rated Broad loan market

68

24

24

23

18

16

12

11

10

7

6

5

5

2

2

1

1

1

1

1

0

0

2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 YTD

As of 08/31/22. Source: PitchBook LCD. Past performance is no guarantee of future results. In framing our outlook, we point to a few observations:

Declining market prices for higher quality senior loans are warranted but likely temporary given the fundamental performance of these issuers in the market.

■ Among a sample of 153 public loan issuers tracked by LCD, the weighted average interest coverage ratio remained healthy at 5.6X as of June 2022, supported by solid year-over-year EBITDA growth of 11%. ■ Most issuers appear to have reasonable headroom to absorb increased borrowing or a decline in earnings should the economy enter a mild to moderate recession. ■ A prolonged recession would likely increase defaults, particularly in certain sectors and among the most leveraged issuers. (A portion of that “loss-given-default” risk appears to be already priced into the market.) ■ While today’s historically low default activity is likely to tick up at some point, we see no indications that the increase would be widespread, and we expect stress to be concentrated in certain sectors. (BB rated credit should exhibit even less stress than lower-rated cohorts.)

1 As of the 12 months ended 08/31/22, as measured by the amount outstanding reported by the Morningstar LSTA US Leveraged Loan Index.

3

Made with FlippingBook - Online Brochure Maker