Borrowers and lenders are seeking new opportunities in the face of growing market volatility
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
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?
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
During 2021, after months of regulatory pressure to end reliance on the London Interbank Offered Rate (LIBOR), concerns were mounting that the US leveraged loan market was being too slow to adopt the Secured Overnight Financing Rate (SOFR) as the new benchmark for pricing loans.
However, much to the relief of regulators, lenders and borrowers have handled the transition with minimal disruption. Fears that the market would not be ready to meet the January 2022 deadline for US regulated banks to cease using LIBOR on new loans have not materialized.
The success of the transition can be attributed in large part to the endorsement of Term SOFR by the Alternative Reference Rates Committee (ARRC), a group convened by the Federal Reserve Board and the New York Fed to guide the switch from LIBOR in the US.
Prior to this endorsement, the US loan market had displayed little enthusiasm for switching to SOFR. While LIBOR is a forward-looking rate that is known in advance for a given interest period (or tenor), SOFR is inherently a backward-looking rate, based on overnight transactions in the repo market for US Treasuries. Therefore, the amount of interest due on a loan tied to daily SOFR cannot be known until on or near the payment date.
Because the US loan market had relied on LIBOR for decades, market participants were accustomed to knowing the interest rate that would apply to their loan at regular intervals in advance, and loan documentation was structured accordingly. The shift to a backward-looking, "in arrears" rate such as SOFR would have required substantial changes to loan document conventions and operational systems.
Term SOFR, however, uses data from the SOFR futures market to generate a forward-looking rate reflective of market expectations for SOFR's trajectory. This rate operationalizes much like LIBOR, giving parties certainty over the interest rate that will apply for the chosen tenor, and slots into LIBOR-based loan documentation with relative ease. It is now the dominant benchmark in the US loan market, with Debtwire Par estimating that, by the end of April 2022, approximately 96 percent of recently issued loans had adopted SOFR.
To further assist with the transition, the Loan Syndications and Trading Association (LSTA) published a model Term SOFR credit agreement containing defined terms and operative provisions for Term SOFR, which has been adopted by many market participants in the interests of using a single, consistent approach.
Moving forward and falling back
While the switch to SOFR for new loans has gone as planned, new issuance is only a small portion of the overall loan market. There are still a large number of existing LIBOR-based loans that have yet to transition to the new benchmark.
While US-dollar LIBOR can no longer be used for new loans funded by US-regulated banks (and many non-regulated institutions have adopted policies supporting this approach), the most popular tenors of the rate are still being published and can be used for loans funded prior to 2022. However, by June 2023, all tenors of US-dollar LIBOR will be discontinued, and a new benchmark will need to apply to all loans that still use LIBOR. Documentation for most of these loans will include some variation of fallback language, which allows parties to agree on what basis a LIBOR-linked loan will transition to an alternative benchmark.
The two primary categories of fallback language are the amendment approach and the hardwired approach.
Under the amendment approach, the loan agent and the borrower can agree on a rate to replace LIBOR and the related mechanics. The "Required" or "Majority" lenders are typically granted a negative consent right, and if they do not object to the amendment within a specified timeframe, the rate switch becomes effective.
The hardwired approach, meanwhile, specifies the choice of the replacement rate upfront (typically pursuant to a waterfall of possibilities starting with Term SOFR) and typically uses the spread adjustment values recommended by the ARRC.
With the replacement rate and spread adjustment set in advance, the hardwired approach requires no further consent from lenders. However, despite a common misconception in the market, the presence of hardwired fallback language alone is not sufficient to implement the replacement of LIBOR. There are a number of technical, administrative and operational changes that need to be made to the loan agreement in order to implement the replacement rate, which means an amendment (typically signed by the agent and borrower without lender consent) will still need to be completed even when hardwired fallback language is used.
Coming to grips with these details and formulating a clear transition strategy will be key to clearing the June 2023 LIBOR discontinuation deadline for pre-2022 loans with minimal disruption.
Developments around the application of credit spread adjustments (CSAs) to SOFR loans are also high on the transition priority list.
CSAs are used to address the gap between LIBOR and SOFR when pricing a loan with a margin that is not otherwise adjusted. LIBOR is a forward-looking unsecured rate that factors in counterparty credit risk and has therefore historically tracked higher than SOFR, which is a backward-looking secured rate that does not carry any element of credit risk. For any lender switching from LIBOR to SOFR on a loan with the same pricing margin, the upshot is that the lender would likely receive a lower all-in yield without the application of a CSA.
For legacy LIBOR loans that include the ARRC's hardwired fallback language, fixed CSAs will apply, based on the historical difference between USD LIBOR and SOFR over a five-year period preceding March 2021 (when the cessation dates for LIBOR were formally announced). These CSA values are approximately 11.4 basis points (bps) for one-month interest periods, 26.2 bps for three-month interest periods and 42.8 bps for six-month interest periods.
There has been, however, a noticeable variation around CSAs on new loans in 2022, as it is typically a negotiated point between borrowers and lenders. To-date this year, publicly available data indicates that the CSAs on most new SOFR loans have come in below the fixed CSAs recommended by the ARRC, with either a 10/15/25 bps CSA scale for one-month, three-month and six-month interest periods, or a flat 10 bps CSA for all interest periods being most common. There have also been a growing number of transactions where borrowers have received SOFR loan pricing without any CSA or discernable adjustment to the margin.
For borrowers with pre-2022 debt that may convert to SOFR at the ARRC-recommended CSA rates pursuant to a hardwired adjustment, this means the market for a new loan might be more favorable (although of course other broader market considerations may weigh against that approach).
As a result, some borrowers may be holding off on the work of switching to SOFR to assess whether a broader amendment and/or refinancing transaction could allow them to secure better all-in pricing. But a cliff edge is approaching—all deals must be amended before June of next year.
The longer market participants play this waiting game, the greater the risk of a transition bottleneck.