Estimated reading time: 3 minutes
The article in brief:
- While changes in B-Rated Loan Industry Discounted Spreads can help illustrate pricing trends for valuation purposes, changes need to be interpreted with caution.
- Groups of specific Loan or Bond comparables remain the preferred method.
Since February 2020, primary middle-market loan issuance has been minimal due to COVID-19 driven uncertainty. When performing valuations, secondary loan index levels and trends are often considered as pricing indications and a review of the limited primary leveraged loan and high-yield bond issuance.
Considering the virus’ material impact on specific industries, we’ve seen a greater emphasis on secondary industry-specific loan indexes (specifically the B-rated industry-specific loan indexes) as proxies for changes in market participants’ required rates of return when controlling for credit risk.
In general, the secondary indexes are good barometers of investor sentiment and market trends. However, unlike the primary markets, they are exposed to over-levered credits, changes in documentation requirements, and technical selling pressure. Therefore, levels reflected in secondary indexes may not be fully reflective of company fundamentals and pricing for a new-issue deal with updated market-clearing terms.
Along with the concerns mentioned above, the secondary B-rated industry-specific loan indexes pose certain challenges, limiting their usefulness as direct benchmarks in valuation analysis. This post will explore some of the issues that may be present and require further analysis.
B-Rated Industry Changes in Discounted Spreads
A simple interpretation from our first chart is that, based on discounted spreads, the Oil & Gas index’s required return increased to the greatest extent since February 2020, while the Cosmetics/Toiletries index experienced tighter investor-required returns. Without further review, this line of reasoning may misrepresent underlying trends.
We will use the Cosmetics/Toiletries index to demonstrate why the simple interpretation is not always correct.
The secondary indexes represent time-series data of the weighted average discounted spreads of an underlying group of qualifying loans for a given period. Therefore, the makeup of the underlying group is subject to change, along with any rating changes. During times of stress, where there are adjustments to significant portions of the rated loan universe, this can cause volatile comparable groups.
For instance, since February 2020, the Cosmetics/Toiletries index’s makeup has shifted, which resulted in the addition of a larger, higher-rated loan (Coty) and the removal of a mid-size lower-rated loan (Anastasia). However, the index has consistently had a limited sample size, which is common among the available indexes, as shown in our next graphic.
During times of stress, where there are adjustments to significant portions of the rated loan universe, this can cause volatile comparable groups.
As a result of limited sample size and volatility in the underlying loans, index averages that reflect weighted averages based on the initial amount may give misleading indications. For the Cosmetic/Toiletries index, the changes resulted in the decline in the index discounted spread since February 2020, while the underlying loans exhibited higher discounted spreads.
Also, the weighted average does not fully reflect that there is a material dispersion among the individual indications and that they are not clustered tightly around the average. Therefore, the industry is but one attribute to consider when determining the appropriate required return.
Other characteristics can include differences in capital structure, fundamental performance, liquidity, market demand for the loan, etc. Reliance solely on the indexes may not compare how the subject loan relates to the other factors that may justify an adjustment away from the weighted average.
Furthermore, as ratings are not updated daily, the discounted spread may indicate increased credit profile risk than implied by the stated rating. This is reflected by Anastasia, which had an equity-like required return in March 2020 but was not downgraded to CCC until April 14th when it was removed from the index.
While not a specific issue for the Cosmetic/Toiletries index, the indexes’ definitions can be relatively broad and contain different sub-industries that are impacted differently from other sub-industries in the index. Therefore, important trends for a sub-industry may not be fully reflected in the weighted average. This is especially the case if the sub-industry is relatively small compared to other sub-industries in the index. Larger loans based on initial amount or larger aggregate numbers of loans within a sub-industry have greater weight and impact on the average.
In VRC’s early-April blog post, we discussed approaching adjustments for COVID-19 impacts and risks, noting that, at that time, all market participants were segmenting industries and companies into low-, medium-, and highly impacted. In the absence of sufficient primary market indications, the secondary B-rated industry-specific loan indexes are good barometers of investor sentiment and market trends.
However, as noted above, changes in the weighted average need to be interpreted with caution, and further analysis may be required. Therefore, the preferred method remains to select an individual secondary comparable group for the subject security and track changes in the individual components over time relative to the subject security.
This type of bottoms-up analysis considers that there are differences among companies and securities not captured purely by industry. As a result, these differences can result in conclusions not indicated by the weighted average index.
As more information becomes available, we will continue to review and incorporate fundamental and market data into our private investment valuations and advise our clients appropriately.
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