Middle Market Credit Spreads and Required Returns

An Update Reflecting on Fourth Quarter 2020

By: Adrian Lowery

Estimated reading time: 2 minutes

A 20/20 on 2020

The fear of the pandemic’s potential negative impacts on global capital markets was at its worst in late Q1 2020. From the second to the fourth quarter of last year, market tone improved amidst easing COVID-related restrictions, reopening economies, government stimulus, and better than expected company performance and liquidity relative to worst-case expectations. As a result, secondary and primary equity and levered finance markets recovered and the price of risk declined.

As markets reopened in Q2 2020, investors were mainly focused on high-quality, low COVID impacted credits with moderate and high COVID impacted credits requiring premiums and/or lower relative risk. In Q3 2020, competition led to decreasing credit spreads for all segments. However, the market continued to demand higher returns for moderate and high COVID impacted credits relative to low COVID impacted credits.

Fourth Quarter Brings Clarity & Comfort, Yet Uncertainty Remains

In Q4 2020, market participants noted improving comfort with company and industry fundamentals, outlooks, and ability to weather a second wave of the virus. This, coupled with high demand for credits with low COVID impact, resulted in increasing demand for credits with moderate COVID impact, and the difference in required returns for low and moderate COVID impacted credits compressed materially. Note that more storied, high COVID impacted, or marginal issuers continue to require a premium if they can secure financing at all.

Credit spreads for first-lien, second-lien, and unitranche loans remain ~125 to 150 bps above pre-COVID levels given an 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 ~100 bps tightening in credit spreads since Q2 2020 (~25 bps in Q4 2020).

Since 4Q 2019, wider credit spreads were offset by lower spot and forward LIBOR curves. As a result, all-in yields are lower as the LIBOR floor benefit did not fully compensate for the decline.

Credit spreads are only one piece of the underwriting equation. Through Q3 2020, many lenders reported adjusting term sheets to require tighter documentation, reducing leverage levels by ~1x from pre-coronavirus levels, increasing covenant protection, and adding LIBOR floors of 1% or greater, among other requirements. However, in Q4 2020, many lenders report documentation, leverage, and covenant protection moving more in line with pre-COVID levels for low and moderate impacted credits due to reduced risk aversion from the trends mentioned earlier.

Overall, clarity into performance and outlook for many companies improved during Q3 and Q4 2020, allowing market participants to compete for new issuance. However, uncertainty remains around the impact of the second COVID wave, the consumer, and company-specific fundamental performance adjustments related to COVID impacted periods.

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 continue to fare better than others.

New Year Brings Not-so-New Expectations & Queries

As we move into 2021, VRC continues to monitor market tone and expectations as COVID continues to impact 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 virus wave or delayed reopenings mean for long-term liquidity?
  • Will governments provide further stimulus programs?
  • How will the Biden Administration impact markets and policy?
  • How will the vaccine roll-out succeed, and what impact will it have on returning to “normalcy”?
  • Have consumer behaviors changed, and what happens when government measures to offset high unemployment end?

Continued Updates and Coverage

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