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.
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.
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?
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
Risks posed by rising inflation, concerns about a global recession and the lingering impact of the war in Ukraine are seeing lenders and investors start to chip away at the loose, borrower-friendly terms that have characterized loan documentation in recent years.
According to Debtwire Par, covenant-lite loans still accounted for 84 percent of institutional loan issuance in the year to the end of June 2022 (only 2 percent less than observed in the bull market of 2021 and equal to or higher than in any other year going back to 2013), but a tougher syndication market is prompting borrowers to move on terms to get deals done.
Analysis by Covenant Review, which scores the covenant strength of loan documents on a 1 (most protective) to 5 (least protective) scale, meanwhile, provides some evidence that lenders are securing more protection in documents. In May, the score on loans reviewed by Covenant Review moved to 3.39, representing the most protective score since August 2020. This compares to scores earlier in the year of 4.14 in February and 3.93 in March.
84%
Covenant-lite loans accounted for 84 percent of institutional loan issuance in H1 2022
The lender pushback on documentation, however, has not been wholesale. High-quality credits and private equity (PE)-backed deals are still able to secure borrower-friendly features like unrestricted subsidiary terms and generous grower baskets embedded in loan documentation. (Grower baskets – typically structured as the greater of a fixed dollar amount and an equivalent percentage of closing date LTM EBITDA—allow borrowers to incur additional debt or take certain other actions, which would otherwise be restricted by lenders, within a set limit or percentage of earnings.)
Borrowers may not be pushing for loose documentation with the same intensity as observed last year, but high-quality credits backed by repeat blue chip sponsors continue to receive favorable terms.
For repeat PE issuers, there has been more flexibility on the lender side. According to Covenant Review, PE-backed loans were able to secure looser terms on loans than other issuers, with a score of 3.51 on the Covenant Review scale in May 2022.
For this select group of issuers, concessions have been around the edges, with borrowers only giving ground on some points rather than a retreat across the board.
For now, flexible covenants that allow borrowers to exclude selected liabilities from leverage calculations are still available, as is additional flexibility on baskets, which gives borrowers room to spend higher thresholds of income on dividends or other investments.
Borrowers have also benefited from a convergence between terms in the syndicated loan and direct lending markets, with the traditionally more-tightly documented direct lending offer moving closer to the syndicated loan market’s approach.
With deal execution risk and pricing flex more of a concern in the current environment, direct lenders have been able to compete with the syndication market by holding credits on their own books and offering borrowers flexible terms.
Some direct lenders are offering debt on a cov-lite basis—a change from the status quo where they would require a financial covenant test at the end of each quarter. Cov-lite deals include one springing financial covenant—typically a leverage test—which only becomes live when a borrower utilizes a revolving credit facility beyond a set threshold, including letters of credit that have been issued.
For financial sponsors borrowing to fund buy-and-build strategies, direct lenders have laid on delayed draw term loans, which give borrowers a credit line that can be drawn down over a long period of time when required to finance add-on deals.
The syndicated market will also provide the flexibility for a delayed draw term loan, but the commitment fee charged by direct lenders is usually much lower and it is also easier for borrowers to extend commitment termination dates with direct lenders, if required.
Basket sizes, calculations of leverage ratios and incremental financing capacity in direct lending documents are also becoming less and less distinct from those in syndicated loans, although direct lenders have begun to hold more ground on terms of late in the wake of the broad disruption in the syndicated markets, which has enhanced their leverage.
In addition to revisiting some of the flexibility in documentation, lenders have also pushed on pricing as a way to mitigate risk. According to Debtwire Par, average margins on first-lien institutional term loans reached 4.31 percent in Q2 2022, well ahead of the first-quarter average of 3.96 percent.
Credit quality has been a key determinant of pricing, with a gap opening between higher and lower-rated credits. For higher-rated borrowers with double-B ratings, margins decreased over April and May. Weaker-rated credits, by contrast, have found it much more challenging to clear syndication and have been forced to price debt generously to persuade investors to come on board. Borrowers with single-B ratings saw margins climb to almost 5 percent in Q2 2022 from 4.18 percent in Q1 2022.
Wider original issue discounts (OIDs) have also become a standard feature of deals in the first half of 2022 to compensate investors for increased risk, and they have moved in lockstep with the falling prices in secondary markets. According to Debtwire Par, discounts averaged 48 bps in January 2022, but jumped to 473 bps in June as the average issue price of new loans slid to 95.27 percent of par. OIDs continue to deepen, with some new issues now proceeding with OIDs in the high 80s to low 90s.
With interest rates expected to continue climbing, higher pricing is already becoming established as a feature of the market for the medium to long term. Moves toward tighter documentation could follow suit.
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View full image: US covenant-lite share of institutional loans (2013 − H1 2022) (PDF)
