Fitch: Prime Conditions for European Leveraged Credit Borrowers 

Fitch Ratings says that lower spreads, looser covenants and more generous leverage levels indicate that it may never be a better time to be a borrower in the European leveraged credit market, especially before the European Central Bank (ECB) imposes leveraged lending guidelines on arranging banks in June 2017. However, in the latest quarterly edition of its 'European Leveraged Loan Chart Book' Fitch observed only five new primary market issuers in 1Q17, while the combination of rising senior leverage levels and weak covenant standards erodes the outlook for senior secured recoveries.

The material shift towards lower funding costs is driven by central bank policy rate and asset purchase programmes initiated in 2016, the impact of Solvency II on European insurance industry demand for privately rated loan products, and cross border demand from Asian banks for the senior notes of collateralised loan obligations (CLO). However, sustained conditions of excess demand for European leveraged loans are constrained by an over-reliance on financial sponsors for new assets.

The primary market median EV multiple in 1Q17 set a new post-crisis high, in excess of 2007 levels of 10x EBITDA, despite much weaker top-line and operating profit performance among European corporates. Median total gross leverage, in turn, recovered its 2007 level of 6x, after stabilising around 5.5x in 2016. Some sponsors are prepared to accept lower target returns by contributing substantial equity in new transactions, but fierce competition from trade buyers in vendor auctions makes valuation a key constraint on new buyout activity. The scarcity of primary buyouts means that repricing and refinancing activity, often for the purpose of bolt-on acquisitions, continued to dominate issuance activity as highly leveraged second lien, mezzanine and even unsecured bond issuers refinanced into all senior loan structures.

The median margin spread on term loan Bs continued to decline below 400bp and enabled some widely-held 'B' category rated leveraged borrowers to secure record-low margins in 1Q17, such as French laboratory testing company Cerba Healthcare (300bp, 0% floor), incentivising others to solicit a repricing of legacy debt from lenders. Meanwhile, the number of dividend recaps picked up from 2015-16 levels and fully covenanted loan structures completely disappeared, at least in the 17 buyout and refinancing transactions seen by Fitch in 1Q17.

The lower margin achieved on non-amortising seven-year term loan Bs provides additional debt service and cash flow flexibility for borrowers, which compensates, in the near-term, for increases in leverage. This, together with indications of improving GDP growth across the eurozone explains why the median credit quality in Fitch's portfolio has remained stable over the 12 months to March 2017.

However, higher senior leverage also results in lower expected recoveries on event of default. Consequently, many CLO managers face constraints on their ability to meet minimum weighted-average spread tests and weighted average recovery tests even as debt service metrics and operating risk profiles improve. These constraints together with anticipated 'tapering' of monetary policy stimulus in Europe indicate characteristics of a peak in borrowing conditions.

Nonetheless, default rates are set to remain at post-crisis lows for the next few years. Ample debt service headroom and long-dated maturity profiles support a benign default rate outlook into 2018. Fitch's 'at-risk' portfolio, which captures 'b-*'/Negative Outlook and below COs has remained around 13% of Fitch's total portfolio since mid-2015. Some isolated distressed issuers will continue to feature in vulnerable sectors like non-food retail but Fitch expects leveraged loan default rates to remain around 1%-2% in 2017, below historical average.