COVID & U.S. Portfolio Securities Valuation: An update on credit spreads and required returns

By: Adrian Lowery

Estimated reading time: 1 minute

In late Q1 2020, concerns about the economic impact of COVID-19 and worldwide efforts to counteract it negatively affected global capital markets. In Q2 and Q3 2020, market tone improved as COVID-related restrictions eased, economies reopened, government stimulus influenced markets, and companies generally outperformed worst-case expectations and secured sufficient near-term liquidity. As a result, secondary equity and credit markets rebounded, primary equity and levered finance markets reopened, and the price of risk declined.

During Q3 2020, lenders looked to deploy capital and private equity sponsors were eager to complete transactions ahead of the U.S. election and take advantage of lower purchase price multiples for add-on opportunities. Therefore, direct lenders report increasing competition for high-quality credits with low COVID exposure, although issuance remains below pre-pandemic levels.

Spreads Find a New Level

Credit spreads for first-lien, second-lien, and unitranche loans remain ~150 to 175 bps above pre-COVID levels given increased risk aversion and the LIBOR floor benefit from the decline in spot LIBOR below the average LIBOR floor of ~1%. However, given the competitive market dynamics, market participants report a ~75 bps tightening in credit spreads since Q2 2020. Also, the difference in credit spreads for low and medium COVID-impacted industries has narrowed. Note that more storied, COVID-impacted, or marginal issuers may have to pay a premium or adjust other terms to reduce relative risk if they can secure financing at all.

Since Q4 2019, wider credit spreads were offset by lower spot and forward LIBOR curves. As a result, all-in yields are flattish to lower as the LIBOR floor benefit did not fully compensate for the decline mentioned above. If spot LIBOR falls below a floating-rate security’s LIBOR floor, then that security effectively is a fixed-rate security for as long as that condition holds.

However, credit spreads are only one piece of the underwriting equation. Many lenders continue to adjust term sheets to require tighter documentation, reduce leverage levels by ~1x from pre-coronavirus levels, increase covenant protection, and add LIBOR floors of 1% or greater, among other requirements. Therefore, similar to Q1 and Q2 2020, lenders continue to pursue reduced risk.

Overall, clarity into performance and outlook for many companies improved during Q3 2020, allowing market participants to compete for new issuance. However, uncertainty remains around a potential COVID second wave, the U.S. election, and company-specific fundamental performance adjustments related to COVID impacted periods. As a result, market participants continue to underwrite more conservatively than pre-COVID levels.

We expect valuations to reflect tightening market yields for existing portfolio securities and incorporate fundamental and technical data as it becomes available. Valuation analyses need to consider case-by-case situations focusing on fundamental pandemic impacts, the benefits of any offsetting measures, outlook, and liquidity. Therefore, some credits will fare better than others.

Looking Ahead to the Remainder of 2020

As we move into the final quarter of the year, VRC will continue to monitor market tone and expectations as COVID continues to impact the markets:

  • Fundamentals are generally better than original worst-case expectations but still under pressure.
  • Many companies secured sufficient liquidity for the near-term, but what does a second wave or delayed reopenings mean for long-term liquidity?
  • Will governments provide further stimulus programs?
  • How will the U.S. election results impact markets and policy?
  • Have consumer behaviors changed, and what happens when government measures to offset high unemployment end?

Continued Updates and Coverage

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