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?
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
Environmental, social and governance (ESG)-linked debt issuances have been negatively impacted in 2022 after reaching all-time global highs last year.
According to Bloomberg, by the end of April 2022, global sales of sustainability-linked loans had dropped by just under a third (32 percent), year-on-year, reaching US$91 billion. Sustainability-linked bond issuance during the same period fared better, rising more than 70 percent, year-on-year, to US$36.4 billion—although activity dropped off significantly between March (US$15.2 billion) and April (US$4 billion) as investors retrenched following events in Ukraine and an increased focus on greenwashing concerns in Europe.
Despite recent volatility, the outlook for growth in ESG-linked debt remains positive. Borrowers continue to successfully secure ESG and green finance. In May, for example, American Express raised US$1 billion for its first-ever ESG bond, with proceeds earmarked for improvements to its office energy efficiency, as well as investing in renewable energy and making a higher proportion of credit cards from recycled plastic.
Fighting climate change and pursuing the transition to sustainable energy sources have become key policy priorities for governments worldwide, while consumers and retail investors are paying closer attention to the environmental and social impact of their spending. These factors are driving private sector institutions to embed ESG criteria in capital allocation and investment decisions.
Challenges around inflation and energy prices have checked momentum to a degree, but the long-term direction points to ongoing integration of ESG into investment decision-making and a long runway for future growth of ESG debt issuances.
With the market pausing in February due to events in Ukraine, lenders had the opportunity to pay closer attention to both the materiality and reporting of KPIs. The means by which KPIs are set is varied, but lenders now want KPIs that are appropriate for each credit and agreed upfront.
Among leveraged loan and high yield bond stakeholders, the emergence of sustainability-linked debt facilities has been a valuable tool for accelerating the ESG transition in debt markets.
Unlike green loans and bonds, where use of proceeds is limited to specific qualifying green projects (like renewable energy developments), sustainability-linked facilities have been available to all issuers across all sectors. Sustainability-linked debt puts a ratchet mechanism in place where the margin on a corporate loan or bond can move up or down depending on compliance with a set of pre-agreed ESG key performance indicators (KPIs). These KPIs are tied to the company's ESG goals rather than the features of a specific project being funded with the proceeds of the loan or bond.
Even issuers in industries like oil & gas have been able to tap into sustainability-linked debt markets, demonstrating the broad reach of the structure. In February, for example, Canada's Tamarack Valley Energy became the first upstream oil & gas producer in North America to raise bonds tied to environmental and social goals. Tamarack raised a CAD200 million bond maturing in 2027 with a coupon of 7.25 percent. The interest rate payable on the bond will step up if the company does not achieve cuts to scope 1 and scope 2 carbon emissions and fails to increase the number of indigenous workers on its payroll.
In addition to making ESG-linked lending available to a broader pool of borrowers, the market in North America is also positioned to expand as it catches up with the more established ESG debt market in Europe.
According to analysis from Nordea, Europe is the largest market for ESG debt in the world, with European issuers accounting for approximately half of global activity. Other markets, however, are closing the gap, and it's become more common for leveraged loan and high yield bond deals to include some discussion around ESG KPIs as issuers consider their options.
As the ESG-linked debt market matures and consolidates, investors and lenders want to ensure that the KPIs linked to margin step-ups are meaningful and measurable.
With the market pausing in February due to events in Ukraine, lenders had the opportunity to pay closer attention to both the materiality and reporting of KPIs. The means by which KPIs are set is varied, but lenders now want KPIs that are appropriate for each credit and agreed upfront.
The market has also moved to ensure that borrowers are reporting on KPI compliance and that there is third-party verification of KPI performance.
In 2021, the Loan Syndications and Trading Association (LSTA) updated its Sustainability Linked Loan Principles to include tighter standards for selecting KPIs and mandatory independent, external verification of performance against KPIs. As the market has expanded, the LSTA has continued to refine its guidelines and recently released additional guidance outlining best practices for the external review process.
The LSTA's focus on improving industry standards has coincided with closer regulatory scrutiny of all ESG financial products and greenwashing risk. In the ESG funds space, for example, the Securities and Exchange Commission is developing so-called nutrition label rules that will require disclosures on how ESG funds are marketed and how ESG is built into investment decisions. Regulation of the ESG-linked debt space could follow suit.
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