Loans and high yield bonds make a comeback as economic vitality breeds confidence among investors and issuers
Leveraged debt is alive and kicking
It has been a banner year for the leveraged debt markets, and despite a number of political and economic headwinds, 2018 could be even stronger.
As we enter a new year, we are happy to report that the leveraged finance market is flourishing in Europe and the rest of the world. This welcome news comes after a disappointing 2016 and an uncertain start to 2017.
And it is even more welcome against a backdrop of geopolitical uncertainty across the world. Fortunately, the global economy has been more benign, with the US and EU showing growth and many emerging economies strengthening.
As we predicted in the previous issue of our report, the ongoing competition for market position between the covenant-lite term loan B and high yield bonds continues. The term loan B had a strong start to the year, although high yield caught up later in 2017 with a surprising surge. High yield had a momentary pause in the third quarter, as market participants caught their breath from the robust round of activity, but the fourth quarter saw a renewed uplift.
Convergence, which has been a long -running theme in all of our annual reports, continues unabated. In 2017, the meeting of the minds between the US and Europe has taken the form of both regions seemingly trying to outdo each other in the covenant flexibility or covenant erosion realm, depending on your point of view.
And what of the year ahead? There is every reason to believe that the trends seen in 2017 will continue—at least, in the short term. However, there could well be headwinds, as geopolitical uncertainties exert their influence. MIFID II, new ECB regulations, Brexit and interest rate increases could weigh heavily on EMEA markets in 2018. However, attention will be on the developments in the US where there is talk of deregulation under the Trump Administration, which runs counter to the continuing tightening regulatory environment in Europe.
On a positive note, buy-side demand remains strong with sell-side assets available. As a result, we can expect a combination of refinancings; private equity and acquisition-based lending; and opportunistic (including dividend) new money deals. There should also be interesting prospects in a more settled high yield market, a bridge-to-bond and term loan B product mix as well as the more traditional European bank financing structures. Other financial products, such as asset-backed securitisations, are expected to add to this diversity of options, and an optimist may even argue that adapting to new regulation will create new opportunities.
White & Case partners Rob Mathews and Lee Cullinane explain how 2017 was a banner year for loans and high yield bonds in Europe and discuss the strong prospects for European leveraged debt markets in 2018.
• Leveraged loan value outstripped 2016 level by €131.3 billion in 2017 • Value of high yield bonds has surpassed 2016 by 32 percent • Refinancing and repricing drive the market • Leveraged loans continue primacy over high yield bonds
8 min read
While geopolitical risks dominated headlines in 2017, the European leveraged debt market did its best to ignore the vagaries of Brexit negotiations, the unpredictable Trump Administration and a spate of continental elections. Instead, issuers took advantage of attractive market conditions, while investors continued their search for higher yielding assets as the European Central Bank (ECB) continued to put money into the system with interest rates hovering at zero.
While election victories for moderate candidates in France and the Netherlands brought greater stability to the continent, the most important incentive may have been the improving global economic picture.
Europe continued its strong recovery, with the International Monetary Fund's (IMF) November Regional Economic Outlook showing that the continent had become an engine of global trade. According to the IMF, the euro area economy is on track to grow at its fastest pace in a decade this year, with real gross domestic product (GDP) forecast at 2.2 percent— substantially higher than the 1.7 percent estimates made in the spring. The EU economy was expected to outstrip expectations with robust growth of 2.4 percent in 2017, up from 1.7 percent in 2016. However, unlike in the past, the ECB is holding fire, and interest rates are not expected to increase until mid-2019. This is in contrast to the UK and US, which have both begun a slow and steady path back to what may be recognised as monetary normalcy.
Meanwhile, US GDP expanded at a 3.1 percent rate in the second quarter, having dipped in the first quarter, and at 3.2 percent in the July to September period, beating analyst expectations of 2.5 percent.
Issuance across both the leveraged loan and high yield bond markets got off to a strong start, and the momentum continued through the majority of 2017.
While initial predictions for 2017 were for a swing to the term loan B leveraged loan market, as the year began high yield proved to be a resilient product choice. Leveraged loan deals reached €282 billion in 2017, topping the €151 billion posted in 2016. It was a similar story for high yield bonds, which saw issuance at €114 billion, surpassing the 2016 figure of €86 billion.
While loans kept pace through the year, high yield activity reduced somewhat in the third quarter. However, the pause was temporary and attributed to market participants catching their breath and preparing for the next wave of transactions in the fourth quarter.
Markets benefitted from a decent pipeline of leveraged buyout (LBO) deals, but there were not enough event-driven deals to meet demand. As with last year, the real impetus was re-pricings and refinancings, as companies looked to lock in funding and push out maturities. These accounted for 55 percent of leveraged loan issuance by value, while 45 percent emanated from new money. This represented an increase from last year's figures where the refinancing component comprised 51 percent of the total tally and a substantial jump from the 38 percent reported in 2015.
Investor appetite was reflected in the strong demand for the Italian telecom group Wind Tre's issue, which was the largest refinancing transaction of the year. It came to the market with €7.3 billion worth of high yield senior secured notes and €3.4 billion worth of loans.
As in the past couple of years, leveraged loans have trumped high yield bonds, although bonds fought back toward the year end. Loans comprised 71 percent of leveraged debt issuance in 2017 while high yield bonds accounted for 29 percent, according to Debtwire research. This was partly driven by the buoyant demand for collateralised loan obligations (CLO), which not only offer better risk-adjusted returns than other fixed income strategies but whose floating rate notes offer protection against a rising rate environment. Borrowers have tended to prefer leveraged loan structures because they do not require public reporting and often are cheaper to repay in an exit scenario, even though their covenant protection may be tighter in certain areas.
Creditflux data showed that European CLO issuance jumped to €7.7 billion in the fourth quarter of 2017—up 54 percent for the same period in 2016. Refinancings and re-sets, which were the main factors, amounted to €2.1 billion and €2.4 billion respectively, during the quarter. Re-set volume for 2017 came in at €13.8 billion, while refinancings stood at €11.4 billion.
US issuers continue to cross pond
Another significant trend is the steady march of US borrowers crossing the Atlantic to diversify their investor base and take advantage of the lower borrowing costs available in the European market. The migration started around two years ago, and reverse Yankee loans have continued their upward climb, reaching €24.8 billion while corresponding bond issuance was €13.2 billion. This represents a year-on-year increase of 116 percent for reverse Yankee loan issuance and 43 percent for reverse Yankee bond issuance. As an example, in September, data centre operator Equinix tapped into the market for €1 billion after initially seeking €250 million.
Meanwhile, the US and European markets continue to converge. Europe has adopted many of the same practices as the US in terms of leveraged loan market practice, execution and documentation.
The spotlight increasingly has been turned on the so-called 'cov-lite' structures (loans that have bond-like incurrence covenants, rather than traditional and more restrictive maintenance covenants). Over the past three years, they have become incorporated into the European fabric, as the market has deepened with a broader and more diverse issuer as well as investor base. For more on cov-lite structures, see Lite for life.
Moreover, loan investors have become more open to looser covenants in exchange for higher returns (in relation to other asset classes) since the ECB launched its corporate-sector purchase programme last May in an attempt to revive inflation. This only served to dampen investment in corporate debt, while the quantitative easing programme introduced in March 2015 has kept government bond yields depressed.
Although there has been some disquiet over this type of documentation, low default levels and accelerating global growth have helped ease concerns. Equally as important, the average leverage on new leveraged loan deals remains below the pre-crisis peak, while the average equity contribution in buyouts is higher than the roughly 40 percent seen between 2013 and 2015. Both factors act as positive forces on recovery rates. In addition, supply-and-demand dynamics, not changes in credit quality, are the main underlying forces, as sponsors and companies are pushing for similar terms they had been receiving from issuing high yield bonds in the post-crisis resurgence of the loan market.
However, there are still some distinct differences between the two regions. The covenant quality protection is somewhat tighter in Europe than in the US, while European leveraged loan borrowers want greater control and are imposing tougher restrictions on which investors can hold debt in portfolio companies. This is typically to prevent distressed or similar investors purchasing debt in a workout. The US, by contrast, is more borrower friendly and the restrictions on the transferability of debt are typically less stringent.