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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

Navigating choppy waters: 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?

Insight
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3 min read

The headlines have looked relatively bleak in recent months, chronicling a mixture of macro-economic headwinds and investor concern. But that’s the nature of markets. Rather than focus on the immediate downturn, it’s worth taking a step back to look at the bigger picture.

For example, while leveraged loan issuance is down significantly year-on-year, this is by no means the slowest half-year on record. As recently as 2019, leveraged loan totals were lower at the halfway mark than they are today and that was without historic inflation rates, a war or a pandemic.

What’s more, the high point for leveraged loan activity in H1 2022 has been buyout activity—issuance reached US$94.5 billion, up 20 percent year-on-year. Private equity firms are likely to continue to pursue opportunities as they deploy the remarkable levels of capital still at their disposal.

On the high yield bond side, while it’s been a rough six months, there are also signs of an uptick in activity—for example, there was more than US$8 billion in high yield issuance in June, versus just US$4 billion in May.

Potential for default remains low

1.5%

Fitch Ratings anticipates the full-year 2022 default rate in the loan market to reach 1.5 percent—still very low despite market volatility

On another positive note, default volumes remain historically low despite years of significant market pressures, and credit quality remains fundamentally healthy.

According to Debtwire Par, most term loan debt currently bid at a price of 80 or lower—at which point it would be considered distressed—is not due to mature until 2025 – 26. Only a handful of distressed loans, valued at U$7.4 billion, are due in 2023, with a further US$6 billion due in 2024.

By comparison, US$39.6 billion will come due during 2025 and 2026, giving companies ample time to refinance any outstanding debt as needed before maturity.

Default rates in both institutional loan and high yield bond markets stand at 0.8 percent—still low despite remarkable levels of volatility. According to Fitch Ratings, the full-year 2022 default rate in the loan market is expected to reach 1.5 percent, with the bond market hitting 1 percent (before ticking up to 1.5 percent in 2023).

All in all, this paints a very stable picture for the months ahead.

CLO superheroes?

And then there are collateralized loan obligations (CLOs), one of the biggest buyers of leveraged loans.

Amid the drought in the primary loan market, CLO new issuance has remained reassuringly consistent, down just 12 percent year-on-year. May’s US$14 billion in new issuance marked the second-strongest month of the year.

It’s possible that higher pricing is contributing to this latest activity—spreads on single-B-rated debt jumped to an average of 450 bps in March and continued to climb to 471 bps in April and 599 bps in May, according to Debtwire Par.

This activity is keeping things ticking in the leveraged loan market for now, though corporate ratings downgrades due to slowdowns in manufacturing or a recession could force CLOs to sell some of their best-yielding holdings. But, for the moment at least, this is a reminder that every downturn hides an opportunity that just needs to be found.

This publication is provided for your convenience and does not constitute legal advice. This publication is protected by copyright.
© 2022 White & Case LLP

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