The recently concluded fourth-quarter earning season provides conclusive – and encouraging – evidence that the rapid decline in leveraged finance defaults over the past 10 months is not just a reaction to pervasive kick-the-can executions, though certainly these have helped. Indeed, since the start of 2008, 31% of leveraged loan issuers have either executed an amend-to-extend, covenant relief amendment or bond takeout. Another 13% simply defaulted.

In the end, though, it’s the improvement economic conditions and credit fundamentals that allowed the long default cycle to finally peak. Take cash flow generation. On average, EBITDA was up 10%, year-over-year, among large, publicly filing leveraged loan issuers, the best performance since 2007.

As a result, the loan default rate eased in February to a 9-month low of 8.59%. All told, it has now receded 2.23 percentage points from November’s all-time high of 10.81%.

The rate will likely fall further in March. The reason is simple math. During March ’09, 5 issuers defaulted on $16.7 billion of loans. Short of a catastrophic increase in defaults, therefore, the rate will almost certainly end March at 5-6%, putting it at a 13-month low.

Lessons Learned
Not that it’s much consolidation to participants, but the painful default cycle of the past 18 months provides an excellent data set of default data to study and advance the practice of credit analysis. A first cut of the data shows that defaults in the latest cycle were driven far more by sector than leverage. That is true, of course, in every recent cycle with retail particularly hard hit in the early ‘90’s and telecom in the early ’00’s cycle. This time around, it was four sectors that made up 52% of all defaults, 43 of 82: auto (11%), real estate (17%), gaming (7%) and publishing (17%).

For issuers in these wounded sectors, initial deal leverage didn’t seem to make much difference to the ultimate outcome, as this table demonstrates:

For sectors that held up better through the recession, by contrast, original deal leverage appears much more meaningful to the ultimate outcome:

This suggest that if a business model of a particular issuer is under assault, the shape of the balance sheet is often less important than such intangible factors as whether the management is nimble, how creative is the CFO and does the issuer have the clout to increase share in a shrinking market.

Harrah’s in gaming and Ford in auto are obvious examples of issuers that were able to avoid bankruptcy despite overall sector woes and high leverage. Both issuers did so, in part, by executing a series of out-of-court deleveraging programs (which were considered defaults for bond holders, but not for the first-lien lenders), including large-scale distressed exchanges and sub-par repurchases of loans and bonds on the open market.

In the real estate sector, meanwhile, the old adage holds: location, location, location, with a dollop of sector: mall operator General Growth Properties clearly is an example of a long-time issuer that got torched by the retail spending slump.

As for publishing, there wasn’t much to do there. With the ad revenue falling, the entire sector was pummeled. Of the 42 S&P/LSTA loan issuers that were performing as of June 30 2008, 14, or a third, are now in bankruptcy. That’s the highest percentage except building and development at 37%.

Taking a step back, the data presented don’t tell us anything new, directionally. The fact is that these two themes – (1) sector selection is even more important than vigilant credit work is obvious and (2) higher leverage inevitably leads to higher defaults, all else being equal – are as old as credit itself. Still, in the spirit that forewarned is forearmed, the data above demonstrate the real-world implications of these market truisms on the most recent class of defaults.

Steven Miller manages the Leveraged Commentary & Data business at Standard & Poors.