After the shock of the financial crisis a decade ago, a new landscape emerged across debt markets and has continued to mature and develop over the past decade.
A boom in M&A activity over the past three years has boosted the market, with the volume of leveraged buyouts (LBOs) reaching levels seen pre-crisis—alongside the debt needed to fund the deals.
Investors, far from eschewing the riskier end of the lending spectrum, have been tempted up the yield curve, seeking out higher returns than those on offer in safer markets where quantitative easing has depressed yields. Encouraged by investors' desire for yield, riskier issuers/borrowers have started to demand looser terms on loans, knowing that investors, needing to deploy capital in competitive markets for deal allocations, would be more likely to accept.
For the moment, leveraged loans are in the ascendancy over high yield bonds, but large M&A deals in 2018 needed both sets of instruments to get across the line, with high yield bonds often required for that extra layer of debt. In addition, the continued growth of direct lending helped to provide financing packages that may not have been available in the syndicated or high yield markets. All the while, a backdrop of infrequent corporate defaults—assisted by low base rates—has comforted markets. Some pushback on pricing by investors was met by issuers, then reversed as the need for yield rebounded. In particular this year, investors have welcomed the return of syndicated debt instruments—2018 was a record year for collateralised loan obligations (CLO), with CLO markets breaking new issuance records in both the United States and Europe.
But if the leveraged debt markets have thrived in the post-crisis era, there are tough obstacles ahead. Geopolitical issues such as Brexit; global trade wars; Italian sovereign debt; volatility in the stock market; and a concern that default rates, low for so long, might begin to trend upwards have given the market pause. Underpinning everything is the US Federal Reserve, which is already leading the way in raising interest rates. The impact of increased borrowing costs is set to echo further afield—and could push other central banks to keep pace or react to the impact it causes.
However, despite uncertainty about what lies ahead, the market remains resilient and deals are still getting done. Ten years on from the darkest days of the crisis, the leveraged debt market has proven surprisingly resilient, but bumps may lie on the road ahead.
Colin Chang
Partner, Paris, London
Jeremy Duffy
Partner, London
A decade on from the onset of the financial crisis, the leveraged debt landscape is almost unrecognisable and continues to evolve as lenders, borrowers and advisers find new ways to come to market
Selected European leveraged loan and high yield bond markets by volume
As the leveraged debt market has matured at pace in the past decade, many are hopeful that it will maintain an upward trajectory, at least in the medium term
White & Case partners Colin Chang and Jeremy Duffy discuss how the European leveraged finance market has changed over the past 12 months and what lies ahead for 2019
• In Europe, leveraged loan issuance is down 28 per cent year-on-year to €202.5 billion in 2018, but is up on all years between 2014 and 2016 • High yield bond issuance is down 37 per cent year-on-year • Leveraged loans retain primacy over high yield bonds
28%
The fall in leveraged loan value in 2017 compared to 2018
€71.2 billion
The value of high yield bond issuance in 2018—down 37 per cent compared to 2017
From protectionism to trade wars to uncertainty over Brexit, 2018 was characterised by uncertainty and volatility. All the while, a divergence in policy between the world's major economies caused lenders and borrowers to sit up and pay attention. In Europe, the UK's withdrawal from the EU, concerns over a new government in Italy, disruption and protests in France and the rise of populism in a number of EU states took the shine off what had been set to be a bumper year in the leveraged debt market. In addition, growth forecasts for the EU fell in 2018. The European Commission estimated the eurozone would grow by 2.1 per cent in 2018, down from the 2.4 per cent growth recorded in 2017. In a report in July, the Commission estimated that growth in 2019 would fall to 2 per cent.
The story in the US has been a different one, with a central bank determined to stop the economy from overheating. Despite having a similar growth rate to Europe in 2017, the world's largest economy looked set to finish 2018 on a 3 per cent increase. This upturn took place despite four interest rate hikes from the Fed, with much of the momentum coming at the end of the year.
Meanwhile, regulators on both sides of the Atlantic have begun sounding the alarm on the amount of leverage in the market. While some observers think there will be intervention, it seems that most believe that regulators may be content to wait for nature to take its course, with a substantial blow-up being enough of a trigger to all market participants to dial down the level of gearing that will be used going forward. This has all led to a change in the dynamics of the market.
A key driver of the downturn was the fall in refinancing activity, as many issuers had completed deals in 2017 and thus did not need to return to the market in 2018
€27.2 billion
The value of new issuance of CLOs in Europe in 2018—a new post-crisis record
The leveraged finance market started 2018 at a feverish pace but slowed down considerably in H2. Overall, European leveraged loan issuance was down 28 per cent year- on-year to €202.5 billion. Meanwhile, high yield bond issuance dropped to €71.2 billion—down 37 per cent compared to the previous year. While the leveraged loan pullback is, perhaps, a correction on the meteoric rise of the instrument, the decline of high yield issuance reflected the continued migration of high yield issuers and new deals to cov-lite loans and direct lending. At €71.2 billion, the volume of high yield issuance for 2018 was way off the €113.9 billion issued in 2017.
A key driver of the downturn was the fall in refinancing activity, as many issuers had completed deals in 2017 and thus did not need to return to the market in 2018. This resulted in high yield bond refinancing activity dropping by 47 per cent year-on-year to €36.8 billion.
At the start of 2017, US interest rates were at just 0.75 per cent. In that year, borrowers in both the US and Europe rushed to market, eager to refinance debt. In 2017, €153.8 billion in leveraged loan refinancing was pushed through in Europe. This helped volume beat previous record levels. However, the story was beginning to change by the end of the year, as the US federal funds rate reached 1.5 per cent. A further 25 basis points was added the following March. As 2018 ended, rates hit 2.5 per cent. This continued increase in the cost of borrowing translated into a 44 per cent drop in leveraged loan refinancing in Europe in 2018—down to €86.7 billion— compared to a year earlier.
However, outside of the refinancing context, the European market benefitted from a number of public-to-private deals and an increase in corporate and sponsor activity—45 per cent of the leveraged loan issuance was used for leveraged buyouts (LBOs) and acquisition activity compared with only 26 per cent for refinancings. There was a spate of bumper deals, including Advent's acquisition of Zentiva and Carlyle's purchase of AkzoNobel—both carried out alongside large institutional investors. For more on LBO activity, see page 9.
The slowdown in the second half of 2018 was more pronounced in light of a bumper first quarter, which saw some 'jumbo' M&A deals that required significant financing from all corners of the debt markets. Despite some predicting 2018 to be an 'all-time high' for M&A, the winds of uncertainty blew through markets, leaving sponsors and other potential acquirers opting to wait for calmer waters. While 2018 did not match the heights of 2017, there needs to be some perspective— overall issuance was still up on issuance in 2016.
The split between leveraged loans and high yield bonds skewed in favour of loans in 2018. Loans accounted for 74 per cent of European leveraged finance in 2018, according to Debtwire research
As noted above, the split between leveraged loans and high yield bonds skewed in favour of loans in 2018. Loans accounted for 74 per cent of European leveraged finance in 2018, according to Debtwire research. Compare that with a more even split in 2014, when 54 per cent of European issuance was leveraged loans and the rest composed of high yield bonds.
Rising interest rates have been one of the main factors driving investors towards loans, given their floating-rate basis (compared to high yield's typical fixed rate basis), which protects investors when central banks hike. In June, the US Federal Reserve announced its seventh interest rate hike since 2015, with a further two rises in both of the following two quarters. In the UK, the Bank of England increased rates to 0.75 per cent (their highest level since March 2009) in August, after an initial 25 basis-point hike in June.
The uptick in loan pricing has been one of the reasons for investors to favour loans. With the gap between bonds and loans narrowing, the potentially looser cov-lite loan terms, as well as more favourable financing features such as control of transfer, the soft-call protection of a loan compared to the hard-call protection of a bond and the non-public nature of loans have enhanced the attractiveness of the loan product. Additionally, loans can be quicker to bring to market and close, and do not require a detailed offering memorandum, which permits a lower outlay on costs and fees.
The growing division between the two parts of the leveraged debt market was also driven by the demand for collateralised debt obligations (CLO). The growth of CLOs has been a decisive factor in the growth of leveraged loans since CLOs favour floating rate products. In Europe, the CLO market set a new post-crisis record, with €27.2 billion of new issuance in 2018, up from €20.1 billion in 2017. The trend for reset/ refinance transactions also continued in 2018, driven by competitive pricing, with a further €18 billion of issuance.
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