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Our Q1 2020 newsletter discussed the precipitous decline in global capital markets and an increase in investors’ required returns due to concerns about the economic impact of COVID-19 and worldwide efforts to counteract it. In Q2 2020, market tone improved with more optimistic expectations as COVID-related restrictions began to ease, stimulative government efforts positively impacted the economy, additional data on the forecasted impact was collected, and many companies secured sufficient near-term liquidity.
As a result, secondary equity and credit markets rebounded in the second quarter, and primary high-yield and leveraged loan markets reopened, albeit at lower volumes. For the direct lending market, investors turned more attention to new issuance or add-on opportunities from assessing impacts and ensuring sufficient liquidity for existing portfolio companies. While many investors report high levels of dry powder and an open for business stance, issuance remains well below pre-COVID-19 levels as underwriting anything but the safest credits remains challenging.
Therefore, determining the price of risk in the direct lending market continues to be arduous, and markets are primarily in “price discovery mode.” Limited new issuance data points and discussions with market participants indicate credit spreads settled ~200 – 250 bps wider than FYE 2019 levels. Note that a portion of the increase is attributable to the decline in Spot LIBOR below the average LIBOR Floor of ~1% as our credit spreads are inclusive of the LIBOR Floor benefit. However, in June 2020, we believe credit spreads tightened somewhat considering the competition for the limited new issuance and an overall more positive tone of market participants.
Investors turned more attention to new issuance or add-on opportunities from assessing impacts and ensuring sufficient liquidity for existing portfolio companies.
Since December 2019, wider credit spreads were partially offset by lower Spot and Forward LIBOR curves. As a result, while yields are wider than FYE 2019, the magnitude of the increase is less than indicated by credit spreads as the LIBOR Floor benefit did not fully compensate for the aforementioned decline.
We note that credit spreads are only one piece of the underwriting equation. Many lenders continue to adjust term sheets to require tighter documentation, lower leverage by ~1x from pre-coronavirus levels, increased covenant protection, 1% or greater LIBOR Floors, and pricing grids, among other requirements. Therefore, similar to Q1 2020, lenders continue to pursue reduced risk and increased compensation for underwritten risk.
Overall, the outlook for many companies remains highly uncertain, and credit spreads remain wide to pre-virus levels. Higher-quality issuers (e.g., low COVID-19 impact or exposure) are generally pricing tight to more storied, COVID-19 impacted, or marginal issuers. Lower-quality issuers may have to pay a premium or adjust other terms to reduce relative risk if they can secure financing at all.
For existing portfolio securities, we expect valuations to reflect wider market yields and incorporate fundamental and technical data as it becomes available. Valuation analyses need to carefully consider case-by-case situations with a focus on COVID-19 fundamental impacts, the benefits of any offsetting measures, outlook, and liquidity. Therefore, some credits will fare better than others, and the relative strength of the factors mentioned above should be weighed and reflected in fair value estimates.
As we move into Q3 2020, VRC will continue to monitor market tone, and expectations as the pandemic continues to impact markets, leaving many unknowns:
- Fundamentals are generally better than original worse 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?
- Have consumer behaviors changed, and what happens when government measures to offset high unemployment end?
Continued Updates and Coverage
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