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US leveraged finance: Navigating choppy waters

What's inside

Borrowers and lenders are seeking new opportunities in the face of growing market volatility

Foreword

After cresting record levels of activity last year, US leveraged finance markets slowed in the first half of 2022 as lenders and borrowers adapted to a rapidly shifting geopolitical and macro-economic backdrop—deals continued to be done, but stakeholders reset expectations as debt costs rose and investors became increasingly risk-averse.

US leveraged loan markets are in a very different place than they were just six months ago.

Since the beginning of the year, lenders and borrowers have been forced to contend with soaring inflation, rising interest rates, supply chain constraints and an increasingly volatile geopolitical backdrop following events in Ukraine. The contrast with the frenetic levels of activity observed in 2021—characterized by abundant capital, low pricing and buoyant refinancing—is stark.

Macro-economic headwinds took their toll on activity levels. Leveraged loan issuance dropped by a fifth year-on-year in the first half of 2022. The impact was even more pronounced in the institutional loan issuance space, which was down by almost two-thirds on the same period in 2021, as increasingly risk-averse investors tapped the brakes. Some issuers that would have otherwise dipped their toes into leveraged loan markets opted to hold fire instead and await calmer waters.

In the face of these challenges, however, there have been positives. Cash-rich private equity firms continue to close deals and secure financing, cushioning the dip in year-on-year new money issuance. Loan issuance intended for buyouts, while suffering some decline, has also proven resilient. Collateralized loan obligations (CLOs)—the largest investors in leveraged loan assets—have also remained active, even as supply in the primary loan market dried up.

Even as markets take a moment to pause and recalibrate, the door remains open for issuers to secure financing on good terms from debt investors who are eager to put funds to work.

High yield, high costs

For high yield bonds, various headwinds, including rising inflation and interest rates, created a challenging market landscape for fixed rate instruments in the first half of the year. High yield bond issuance dropped to levels not seen since the start of the pandemic, falling by more than three-quarters year-on-year as cautious investors stepped back. According to Lipper funds data, in the first half of 2022, almost US$30 billion left the asset class.

Even in the face of volatile market conditions, stronger high yield issuers have kept a close eye on pockets of opportunities. More than a dozen others have joined the fray since, capitalizing on an improved landscape in June to bring new deals to market. These include Tenet Healthcare, which raised US$2 billion in senior secured notes, and Kinetik Holdings, which priced US$1 billion in senior unsecured notes. Both issuers raised the capital for refinancing.

As we enter the second half of the year, volatility is likely to continue weighing on the market, but investors and borrowers are already adjusting. Activity levels may not hit the buoyant highs of a year ago, but stronger credits should continue to secure investor support. There is no escaping the fact that costs have gone up for issuers accessing the more challenging markets, but patience, adaptability and nimble execution continue to be a successful formula when doing so.

Resilient US leveraged finance markets navigate volatile backdrop

  • Leveraged loan issuance reached US$612.5 billion in H1 2022, down on the US$755.5 billion recorded in the same period in 2021
  • High yield bond issuance also dropped, year-on-year, from US$267.6 billion to US$63.6 billion—though markets began to open again in June
  • Since January, the US Federal Reserve has raised interest rates four times, taking the benchmark federal-funds rate to a range between 2.25 and 2.5 percent
US LevFin 2022

From rising costs to ESG ratchets: Five trends that will drive leveraged finance in 2022

  • Pricing will increase, but issuers will continue to seek borrower-friendly terms and documentation
  • Lenders and investors will pause to assess the impact of inflation and ongoing interest rate rises
  • Direct lenders will take advantage of the volatile backdrop to grab market share from broadly syndicated leveraged loans and high yield bonds
  • ESG opportunities will persist, but lenders will ask more questions
US LevFin 2022

The fund finance market takes flight

  • Fund finance activity soars as PE managers access facilities in ever-greater numbers
  • The market is positionedto grow seven-fold by 2030, reaching an estimated US$700 billion
  • Fund finance products are rapidly evolving from simple bridging facilities into increasingly sophisticated tools used for NAV and GP financing
  • New entrants are growing market and broadening provision to more PE sponsors
US LevFin 2022

Buyout issuance leads the way despite a choppy M&A market

  • In the US, buyouts totaling US$235 billion were announced in H1 2022, far above pre-pandemic levels, year-on-year, going back to 2007
  • Loan issuance for buyouts climbed in the first half of the year, reaching US$94.5 billion
  • High yield buyout issuance enjoyed a strong first quarter, hitting US$7.4 billion, before bond market activity decreased in Q2
US LevFin 2022

ESG: A sustainable approach in turbulent times

  • ESG-linked debt issuance reached record levels in 2021 before macro-headwinds slowed issuance levels
  • ESG-linked KPIs are increasingly a feature in debt structures
  • ESG debt facilities, historically more common in the European market, are expanding rapidly in North America
  • Lender and regulatory scrutiny of ESG compliance and benchmarking is intensifying
US LevFin 2022

Inflation and increasing interest rates reshape US leveraged finance markets

  • US inflation for consumer goods hit a 40-year high in June 2022 of 9.1 percent
  • Since January, the US Federal Reserve has raised interest rates four times
  • High yield issuance for the half-year was down 76 percent year-on-year as investors exited fixed-rate debt instruments
  • Loan markets have also been affected, as pricing and original issue discounts widen
US LevFin 2022

SOFR transition progresses despite volatile markets

  • Almost all new activity in the US leveraged loan market has transitioned from LIBOR to the new SOFR benchmark
  • The Alternative Reference Rates Committee endorsement of Term SOFR in 2021 provided a solid foundation for this transition
  • Attention now turns to how legacy loans tied to LIBOR will handle the SOFR switch
US LevFin 2022

Documentary developments in tighter times

  • Investors are focusing on pricing and original issue discounts to manage risk, but are starting to push back on documentation
  • The flight to quality among investors is driving bifurcation between the terms available to higher and lower-rated credits
  • Direct lenders are offering flexible structures to win deals
US LevFin 2022

A volatile situation: Europe versus the United States

  • Leveraged loan issuance in the US dropped by 19 percent year-on-year in H1 2022
  • High yield bond activity in the US was down 76 percent year-on-year during the same period, hit by inflation and rising interest rates 
  • Combined leveraged loan and high yield bond issuance in Western and Southern Europe was down more than 65 percent year-on-year, as events in Ukraine hit the markets 
  • Pricing is moving in favor of lenders across the board
US LevFin 2022

Conclusion

Taking stock at this point in the year may make for slightly sobering reading for some, but the cyclical nature of the market means that, even as activity slows in one area, it can (and usually does) pick up in another—but what does this mean for leveraged finance markets in the months ahead?

US LevFin 2022
US LevFin 2022

A volatile situation: Europe versus the United States

Insight
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6 min read

Key Takeaways

01

Leveraged loan issuance in the US dropped by 19 percent year-on-year in H1 2022

02

High yield bond activity in the US was down 76 percent year-on-year during the same period, hit by inflation and rising interest rates 

03

Combined leveraged loan and high yield bond issuance in Western and Southern Europe was down more than 65 percent year-on-year, as events in Ukraine hit the markets 

04

Pricing is moving in favor of lenders across the board

Leveraged finance activity slowed on both sides of the Atlantic in the first half of the year, as a tougher macroeconomic environment and events in Ukraine affected debt issuance in both Europe and the US.

The deeper, more liquid US market weathered market headwinds somewhat better than the smaller European market, where exposure to the Ukrainian situation was more immediate due to energy supply chain disruption and geographic proximity, but both markets have encountered headwinds.  

According to Debtwire Par, US leveraged loan issuance reached US$612.5 billion in H1 2022, down 19 percent year-on-year. Despite this, issuance remained steady, topping US$100 billion for four months between January and June, peaking at US$113.9 billion in April. 

US high yield bond activity, meanwhile, stalled in April and May, as investors sought safer alternatives in the higher interest rate environment. As a result, issuance was down 76 percent by the end of Q2 2022, year-on-year—though recent activity suggests that this trend may have bottomed out. In June, there was US$8.6 billion in high yield bond issuance, more than double the total for May.

Issuance in Europe has proven equally volatile. High yield bond issuance reached US$31.1 billion in H1 2022, down 71 percent year-on-year. Markets came close to shuttering altogether in March and April, with just US$2.2 billion and US$2 billion in issuance, respectively, before climbing back up to US$4.5 billion in May. Many issuers were compelled to offer floating rate bond options to keep markets moving—by the end of May, almost a fifth of European bonds had floating rate coupons, up from 12 percent in 2021 and 8 percent in 2020.

European leveraged loan markets have also slowed, with issuance of US$67.8 billion in the first six months of the year, down 65 percent year-on-year. The drop was particularly evident from month to month, from a peak of US$16.4 billion in March—prior to the deterioration of the macro-economic and geopolitical landscape—then dropping steadily to US$4 billion in June. Unlike the US, issuance has also tracked lower for all the main uses of proceeds in Europe, from general corporate to M&A activity, including buyouts. 

One relatively bright spot has been new issuance of collateralized loan obligations (CLOs) in Europe, which was down just 9 percent, year-on-year, at the halfway mark. In the US, by comparison, CLOs were down 12 percent year-on-year, though activity there also remains consistent.  

Inflation and interest rates

-65%

Leveraged loan issuance in Western and Southern Europe was down 65 percent in H1 2022, year-on-year, versus a 19 percent decline in the US

Despite some differences in issuance patterns, US and European leveraged finance markets are nevertheless facing the same inflationary and interest rate pressures. US inflation hit a 40-year high in June, rising to 9.1 percent, while it climbed to 9.4 percent and 8.6 percent in the UK and the EU, respectively, that same month.

In the US, the Federal Reserve moved decisively to try to put a lid on inflation, with interest rate hikes in March, May, June and July. In the UK, the Bank of England (BoE) has upped rates six times since December 2021, reaching 1.75 percent—the highest level in more than a decade. Both bodies are expected to announce further rate hikes this year. In July, the European Central Bank (ECB) raised rates for the first time in more than a decade, by 0.5 percent, with further increases planned later in the year

Pricing pressures

The medium to long-term outlook is for a higher-rate environment to take hold across all jurisdictions, driving up the cost of capital for European and US issuers.

In Europe, institutional loan pricing has been climbing steadily, with average first-lien margins on institutional loans rising to 4.48 percent by Q2 2022, up from 4.2 percent in Q1 2022. A high volume of low-rated credits has elevated pricing, with higher-rated issuers preferring to delay financings rather than brave a choppy market. 

European bond markets have also seen margins swell, with the average weighted yields to maturity on fixed-rate bonds sitting at 6.8 percent by Q2 2022, up from less than 5 percent at the end of 2021.

Pricing has also been trending higher in the US, with overall pricing in high yield markets spiking from 5.71 percent in Q1 2022 to 8.07 percent in Q2. Loan pricing in the US moved upward during the same period as well, climbing from 3.96 percent to 4.31 percent in Q2.

In both the US and Europe, issuers have also been dealing with wider original issue discounts (OIDs) due to the discounts to par available to investors in secondary loan markets. In the US, for example, average OIDs in Q2 2022 climbed to 2.74 percent, up from 0.94 percent in Q1. 

Europe leads on ESG

One area where the European market has been more robust is in the ESG-linked loan and bond space. While European leveraged finance markets have been coping with a volatile market environment, the region has retained its position as the largest market for ESG-linked debt, where loan margins are linked to meeting ESG key performance indicators.

According to Nordic bank Nordea, Europe represents half of the ESG debt market, more than any other jurisdiction. Analysis by Bloomberg confirms this perception—only one of the ten-largest corporate borrowers of ESG debt is based in the US, with the other nine all operating in Europe. 

A strong ESG investor base has allowed European issuers of ESG-linked debt to continue to secure financing. For example, Italian power company Enel, an ESG-linked debt pioneer, issued £750 million in sustainability-linked bonds in April. The offer, which is linked to cutting greenhouse gas emissions, is the largest-ever ESG-linked bond package issued in British pound sterling.

The US is moving to close the gap under the Biden administration, but with the product more familiar to European lenders and the EU’s Sustainable Finance Disclosure Regulation—which defines criteria to qualify environmental and social assets—gaining traction, the US has some catching up to do.

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© 2022 White & Case LLP

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