4Q 2022 Update: Middle Market Credit Spreads, Required Returns

While concerns remain, direct lending markets see some stability in 4Q 2022

By: Adrian Lowery

Estimated reading time: 2 minutes

Since 2021, syndicated markets experienced volatility as capital markets assessed the potential impacts of inflation, the increase in spot reference rates as central bankers tightened policy to combat inflation, the Russian invasion of Ukraine, and recession fears. As a result, syndicated market activity indicated wider primary and secondary credit spreads.

In 4Q22, prices increased quarter-over-quarter, given the improved market tone resulting in tighter syndicated secondary credit spreads versus 3Q22 levels.

Middle Market Leveraged Loan Price and Spread Change Q4 2022

In 4Q22, direct lenders and private equity sponsors noted that their markets found some stability QoQ while the aforementioned negatives remain. As a result, 1st lien, 2nd lien, and unitranche discounted credit spreads were unchanged since 3Q22. However, the widening of Coupon + OID credit spreads earlier in the year (+50 to 100 bps) and reference rates throughout the entirety of the year (+450 bps) drove higher all-in yields from 12/2021 levels by ~425 to 500 bps, after accounting for the Reference Rate Floor Benefit at the beginning of the year.

The change in direct lending credit spreads are at a lesser magnitude than implied by the syndicated loan, high-yield bond, and public equity markets, considering competition for deals, especially those deemed high quality, remains competitive. Investors’ demand for Direct Lenders’ floating-rate securities remains robust.

Direct lenders indicate continued caution when underwriting more storied, inflation-exposed industries or marginal issuers. Therefore, these credits may command a premium relative to more in-favor industries and/or reflect lower leverage levels or purchase price multiples.

Credit spreads are only one piece of the underwriting equation, and many lenders report that, given the concerns mentioned above and higher borrowing costs from increased credit spreads and reference rates, leverage levels and purchase price multiples have come under pressure for some industries, especially those more exposed to inflation, macroeconomic concerns, and high CapEx requirements. While market participants do not note a material shift, they are keeping an eye on CapEx-adjusted interest coverage levels. Given the sudden increase in all-in yields, these are dipping below the traditional 2.0-2.5x lower bound of required levels. VRC will continue to monitor the trend to see if it results in a material shift in leverage levels and purchase price multiples or if credit spreads tighten in response to higher reference rates and all-in yields.

We expect valuations to reflect wider market credit spreads and all-in yields for existing portfolio securities since 2021. Valuation analyses need to consider case-by-case situations focusing on fundamental performance, outlook, affordability of debt, and available liquidity. Therefore, some credits will continue to fare better than others.

Outlook for Q1 2023

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 and leverage levels.
  • Impact of increasing reference rates on market credit spreads as these sometimes tighten with rising reference rates.
  • Impact of recession fears on consumer behavior and companies’ fundamental performance.

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