1Q 2022 Update: Middle Market Credit Spreads, Required Returns

High Competition, Aggressive Terms Still Trending Amidst Increased Volatility in More Liquid Markets

By: Adrian Lowery

Estimated reading time: 2 minutes

In Q1 2022, syndicated markets experienced increased volatility and widening in some secondary markets as capital markets assessed the potential impacts of inflation, the likely increase in spot reference rates as central bankers tighten policy to combat inflation, and the Russian invasion of Ukraine.

However, in Q1 2022, direct lenders and private equity sponsors note similar trends in Q2, Q3, and Q4 2021, including aggressive loan pricing, purchase price multiples, and deal terms. Despite the aforementioned economic concerns and syndicated market volatility, market participants continue to react to high competition. Investors’ demand for floating rate securities remains robust, and direct lenders continue to raise additional capital commitments.

Direct lenders note more caution when underwriting more storied, inflation exposed industries or marginal issuers. Therefore, these credits may not be underwritten at the tight end of terms and may command a premium relative to more in-favor industries.

Credit spreads for first-lien, second-lien, and unitranche loans in the traditional and lower-middle markets and the small market remain ~25 to 50 bps above pre-COVID levels. However, credit spreads materially tightened since 12/2021 as 3-month Spot LIBOR (~96 bps) now approximates the average Reference Rate Floor (~1.00%). As a result, the Reference Rate Floor benefit was reduced by ~75 bps. Coupon, OID, and Reference Rate Floor levels remain similar to 12/2021 levels.

VRC Matrix Q122 Credit Spreads Traditional Middle Market

Credit spreads for first-lien, second-lien, and unitranche loans were similar to ~50 bps wider than pre-COVID levels in the upper-middle market. The lesser magnitude versus the above markets is due to increased competition between the upper-middle and broadly syndicated markets, which results in the migration of large market terms into the upper-middle market (e.g., tighter first-lien discounted spreads, average LIBOR floors of ~0.75%, and inter-credit spread between first- and second-liens below 400 bps.) Credit spreads also declined in the upper-middle market since 12/2021, driven by the increase in 3-month Spot LIBOR. However, the lesser reduction was below the markets as mentioned above due to differences in the market Reference Rate Floors.

VRC Q122 Upper Middle Market Credit Spreads

Direct lenders have been slower than syndicated markets in replacing LIBOR as the reference rate in credit agreements. However, there has not been a material shift in Coupons, OIDs, or Reference Rate Floors for loans using the alternate reference rates relative to those with LIBOR. Notably, most direct lenders favor Term SOFR in the transition and make decisions at the firm level for the appropriate Credit Spread Adjustment, if any, to apply.

We expect valuations to reflect stable market Coupon + OIDs spreads for existing portfolio securities and updated yields accounting for the recent increase in reference rates since year-end relative to the securities’ Reference Rate Floor. Valuation analyses need to consider case-by-case situations focusing on fundamental performance, outlook, and liquidity. Therefore, some credits will continue to fare better than others.

Outlook for Q2 2022

VRC continues to monitor market tone and expectations. Risks to the positive market dynamics remain, including, among others:

  • Impact of inflation and labor shortages on companies’ fundamental performance.
  • Impact of increasing reference rates on companies’ interest burdens.
  • Impact of increasing reference rates on market credit spreads as these sometimes tighten with rising reference rates.
  • Potential spillover of volatility in the more liquid markets into the direct lending markets.