What will drive issuance in a post-COVID-19 world?
Halfway through 2021, we take stock of leveraged finance in the United States and consider the road ahead for both borrowers and lenders. After more than a year of COVID-19, are things returning to normal? Or are we just starting a whole new journey?
In many ways, COVID-19 had far less of an impact on leveraged finance markets than expected. Activity dropped in the second quarter of 2020, primarily in leveraged loan issuance, but a year later numbers returned to pre-pandemic levels. In fact, leveraged loan and high yield bond values reached record highs by the end of Q1 2021—the highest quarter since Q2 2018 and the second-highest quarter, respectively, on Debtwire Par record going back to 2015.
What drove this relatively high-speed recovery? First, the Coronavirus Aid, Relief and Economic Security (CARES) Act, signed into law in March 2020, protected many businesses from the full brunt of the pandemic. At the same time, many businesses shored up their finances, taking on debt to ensure liquidity as lockdown measures continued to have an impact through the second half of 2020. Issuances rose and that upward trajectory carried on into 2021.
By the end of Q1 2021, the picture had changed once again. Vaccines were being distributed quickly and efficiently, raising hopes for a post-COVID-19 future. The economy was also improving, as various states began to open up and a year of pent-up consumer demand was released. By May, core retail sales in the US had reached levels typically only seen over the Christmas period, according to the National Retail Federation. An air of optimism crept into the market, with lenders increasingly willing to take more risks on borrowers in their pursuit of yield. Financing earmarked for M&A and buyout activity also began to climb, hinting at growth plans for the months ahead. Perhaps most significantly, the low interest rate environment gave businesses an opportunity to reprice and refinance their maturing debt in droves.
What's next for 2021?
While these are all very positive signs for lenders in the leveraged finance space, there are still a few red flags on the horizon. First is inflation—in July, the Bureau of Labor Statistics reported that the US consumer price index had climbed 5.4 percent in the 12 months to June, a level not seen in 13 years. These growing inflationary pressures are part of the rush to reprice and refinance existing debt, as businesses try to avoid any unpleasant surprises if interest rates begin to climb as well.
Second, companies in robust sectors that enjoyed a degree of preferential treatment from lenders during the pandemic may find that sentiment shifting in the months ahead as other sectors begin to recover. The "flight to quality" witnessed in the early days of the pandemic will likely return to a more evenly balanced state of affairs. Documentation may also go through some changes in the coming months, as adjustments brought in during COVID-19 are phased out.
Finally, as the dust settles in debt markets, issues that were gaining ground before the pandemic will return in force, especially environmental, social and governance factors, which continue to take on increasing importance among borrowers and lenders alike.
All of which means the road ahead is not quite as clear as many would like, but there will be fewer obstacles blocking the path.
The US leveraged finance story so far
Leveraged loan issuance reached US$763.5 billion in the first half of 2021, up 60 percent from US$478.1 billion in the same period in 2020
High yield bond market issuance also rose 22 percent year-on-year, from US$219.6 billion to US$267.1 billion
Refinancings and repricing deals accounted for 62 percent of overall loan issuance in H1 2021
Refinancing, repricing, M&A and buyout activity all surged in the early months of 2021, but then lenders shifted gears in pursuit of yield and borrowers realized they could tap the market for more than just liquidity. Where will this fork in the road lead for the rest of 2021?
Leveraged loan and high yield bond markets shrugged off COVID-19 uncertainty to post year-on-year increases in issuance in 2021
Features of documents through the COVID-19 period—such as liquidity covenants and EBITDAC metrics—are fading from the market
Lenders are increasingly sensitive to the risk of subordination in either right of payment or lien priority
Leveraged finance markets largely returned to the pre-pandemic status quo in the first half of 2021 following a tumultuous 2020. From January to June 2021, US leveraged loan issuance climbed 60 percent compared to the same period in 2020, and high yield bond activity improved 22 percent for the same period.
The long-term drivers of low interest rates and significant available liquidity, an ongoing trend since before the pandemic, have continued to limit major creditor-favorable shifts to loan documentation.
As vaccine roll-outs progress across the globe and the US economy fully reopens, what are the priorities for lenders and borrowers and what will dictate the direction of leveraged finance through the second half of the year?
The following five trends are expected to shape the US loan and high yield bond markets through the rest of 2021.
1. Expect COVID-19 adjustments to fade
Features intended to mitigate risks for lenders, like liquidity forecasting and increased reporting secured in return for waiving covenants in the immediate response to COVID-19, are now fading from the market.
Waiver changes have either expired or borrowers have been able to refinance or reprice loans in a favorable market and shed these obligations. For the year to the end of June 2021, high yield bond refinancing increased 48 percent year-on-year to US$186.8 billion and leveraged loan refinancing and repricing activity is up 79 percent year-on-year at US$471.7 billion.
On the lender side, so-called EBITDAC (earnings before interest, taxes, depreciation, amortization and COVID-19) measures were used to add-back sales that companies theoretically missed out on because of lockdowns. These are also now being phased out.
EBITDAC allowed borrowers to secure funding against a higher earnings figure when COVID-19 was factored in but, as economies and businesses reopen, lenders are pivoting back to providing credit based on actual EBITDA numbers.
2. Sector lending preferences are starting to disappear
When issuing new debt in 2020, lenders showed a strong preference for credits in sectors that were less impacted by lockdowns. Technology and computer-related leveraged loan issuance, for example, more than doubled between Q2 2020 and Q4 2020.
By contrast, sectors faced with enforced shutdowns saw issuance move in the opposite direction. For example, in the leisure industry, issuance more than halved between the first and last quarters of 2020.
However, as the US economy fully reopens and trading in troubled industries returns to relatively normal conditions, lender industry preferences are becoming less entrenched. Credit quality remains paramount, but a more agnostic attitude toward sectors is re-emerging.
Resilient sectors like technology remain popular—technology leveraged loan issuance spiked through Q1 2021 to US$70.4 billion, the second-highest quarterly total on Debtwire Par record—but sectors that struggled under COVID-19 have also seen significant improvement. Leisure issuance in Q1 2021 reached US$16.1 billion, up 80 percent from Q4 2020 levels.
3. Lenders are focusing on documentation terms
Although lenders have been comfortable issuing debt on cov-lite terms and at attractive pricing for borrowers, there has been a tightening on documentation with respect to super-senior debt capacity and unrestricted subsidiaries.
Through the course of 2020, borrowers were able to find and use flexible structural mechanics in documentation that lenders have now moved to tighten.
There is particular focus in senior loan documentation on limiting the potential for borrowers to bring in new lenders senior to incumbent creditors in the capital structure in return for additional liquidity at cheaper pricing than would be available for unsecured borrowing.
Allowing these super-senior tranches could, in the event of a default, translate to existing lenders being at a higher risk of incurring losses, as their seniority in the capital structure will have been diluted. These scenarios, when effected, have created tensions among lenders within the credit group and have even led to litigation.
Accordingly, when underwriting new deals, investors are now reducing the risk that this will occur by including documentation provisions that allow for a lender vote on any "uptiering" transaction.
Lenders are also tightening documentation to limit the use of unrestricted subsidiaries to shift valuable assets out of the existing credit group to affiliates in order to raise additional debt.
Overall, investors are laser focused on avoiding the risk of being subordinated in either right of payment or lien priority.
4. M&A and LBOs are likely to drive issuance in the second half of the year
Refinancing and repricing dominated activity through the first half of 2021, accounting for 62 percent of US leveraged loan issuance for the year to the end of June 2021 and 70 percent of US high yield activity.
The uptick in US M&A activity seen during H1 2021—up more than fourfold on the same period in 2020—indicates that a rising share of issuance through the second half of 2021 will be attributable either to M&A or LBOs.
In leveraged loan markets, for example, M&A issuance (excluding buyouts) started climbing steadily halfway through 2020, from US$22.2 billion in Q2 2020 to US$58.8 billion in Q2 2021.
Similarly, LBO loan issuance improved from US$12.9 billion in Q2 2020 to US$43.1 billion in Q2 2021, the highest quarterly tally since the fourth quarter of 2018.
5. Inflation could be a big driver for issuance
If inflation remains low, leveraged loan and high yield activity could be expected to sustain the issuance levels observed last year. But that's already changing.
US inflation is creeping higher after a period of declining prices following the first round of lockdowns and oil & gas market price wars, which dropped oil prices to record lows. Figures published in May showed that the US consumer price index had climbed 4.2 percent year-on-year in April, a level not seen since 2008. Capital markets, which anticipated a figure of 3.6 percent, were caught by surprise, and the S&P 500 shed 2 percent on the day the numbers were released. By July, the CPI had climbed 5.4 percent in the 12 months to June, a level also not seen in 13 years. Many asset prices, including for leveraged loans and high yield bonds, have been set against a backdrop of low rates, leaving investors unnerved.
At the end of May, US Treasury Secretary Janet Yellen said that above-normal inflation was expected to persist through the end of the year as COVID-19 supply chain bottlenecks opened up, but this was no cause for concern. Federal Reserve Chair Jerome Powell has also pledged to allow for above-target inflation before considering interest rate rises to support economic recovery post-COVID-19.
It is too early to tell whether the consumer inflation figures are a blip as the market returns to normal activity or signal a longer-term shift. But if inflation figures continue to increase over a longer period and interest rates do go up, leveraged loan and high yield bond markets can be expected to be impacted.
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This article is prepared for the general information of interested persons. It is not, and does not attempt to be, comprehensive in nature. Due to the general nature of its content, it should not be regarded as legal advice.