European loan defaults could increase, says S&P

Although the European loan default rate has been modest in recent years, Standard & Poor’s reports that such may no longer be the case. As both lenders and sponsors adopt a more steadfast approach to financial restructuring, a marked increase in the default rate is plausible.

There are two factors to consider. Firstly, S&P reports that the European loan market structure has to date inherently protected issuers, with lenders and shareholders more willing to aid in cases of financial restructuring. According to S&P’s Leveraged Commentary & Data service, around 76% of loans originated in 2006-2007 were accompanied by financial covenants providing headroom of 25%-30%. However, S&P says that a more unforgiving stance towards restructuring may abrogate such structural provisions.

Secondly, the 12-month speculative-grade default rate is based on defaults of publicly rated companies. As S&P’s report indicates, this is misleading if read in isolation as many European issuance activities occur in the unrated private leveraged loan market. Of the 52 defaults in the year to end-July 2008, Belvedere, a French beverages company, was the only rated company recorded to default. Hence, the speculative-grade default rate was 1.79% in the first half of 2008, compared to 0.97% default rate for 2007.

Repayment for most of the debt is not due for another six to seven years, and resetting of covenants has been facilitated in cases where companies faced performance difficulties. However, as Europe crawls towards economic adversity, the potential for increased default rates remain.