Q1 2021: Middle Market Credit Spreads and Required Returns

Further Recovery & Normalization Toward Pre-COVID Levels

By: Adrian Lowery

Estimated reading time: 2 minutes

In Q1 2021, market participants noted further tightening of credit spreads and more aggressive leverage levels from Q4 2020; this occurred due to increasing demand from and competition among direct lenders. Market participants are reacting to positive vaccination rates, optimism about the economy and company prospects, and demand for floating rate securities, given increased concerns about potentially higher inflation rates.

VRC’s Middle-Market matrix is based on discounted spreads, which reflects the benefit from the coupon spread, LIBOR floor over three-month spot LIBOR, and OID.

However, given the increase in the long end of the LIBOR forward curve, the LIBOR floor benefit will fluctuate with the tenor of a floating rate loan from ~0 to 80 basis points based on an assumed market average LIBOR floor of 1 percent and the implied all-in yield will be higher for tenors with swap rates above the assumed market average LIBOR floor (i.e., floating).

As such, it is essential to consider all-in yields, the changes in the subcomponents of all-in yield, and expectations for forward reference rates in valuation analyses.

In Q1 2021, all-in yields declined further below pre-COVID levels due to continued low LIBOR rates and additional pressure on coupon spreads for first lien, second lien, and unitranche securities. The OID benefit was stable.

All-in yields and credit spreads are only one piece of the underwriting equation. In Q1 2021, many lenders report documentation, leverage, and covenant protection moving more in line with pre-COVID levels for low and moderate impacted credits due to reduced risk aversion. More storied, or COVID impacted securities and industries continue to garner greater scrutiny and tighter terms. However, with the increasing competition and improving visibility into a reopened economy, this may begin to ease.

We expect valuations to reflect tightening market yields for existing portfolio securities and incorporate fundamental and technical data as it becomes available. Valuation analyses need to consider case-by-case situations focusing on fundamental pandemic impacts, the benefits of any offsetting measures, outlook, and liquidity. Therefore, some credits will continue to fare better than others, although many outperformed worst-case expectations at this time last year and moved closer to par valuations.

The Road Ahead

As we move into Q2 2021, VRC continues to monitor market tone and expectations as COVID continues to impact markets:

  • How will the Biden Administration impact markets and policy? Notably, the proposed higher tax rates and infrastructure spending.
  • How will the vaccine roll-out succeed, and what impact will it have on returning to “normal”?
  • Have consumer behaviors changed, and what happens when government measures to stimulate the economy end?
  • Given a reopened economy, how will companies handle potentially higher debt burdens undertaken to secure liquidity?

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