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?
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
The first half of the year has marked an inflection point for US leveraged finance markets. After a buoyant but brief post-pandemic period in 2021, the combination of surging inflation, rising interest rates and events in Ukraine put the brakes on US activity. Overall leveraged loan and high yield bond issuance for H1 2022 was down by 19 percent and 76 percent, respectively, year-on-year.
Moving into the second half of the year, lenders and borrowers will be looking for direction on debt pricing—specifically where it will settle after a volatile first six months—and the long-term impact of rising interest rates on investor appetite for riskier sub-investment-grade debt.
As the market navigates this uncertain period, the following five trends are expected to influence the shape of the market in the second half of the year.
The era of historically low interest rates and abundant liquidity has come to an abrupt end, and borrowers will have to adjust to higher pricing as a result.
US inflation reached a 40-year high this year and the Federal Reserve has lifted benchmark interest rates four times in 2022—by 50 basis points (bps) in March and May and then by another 75 bps in July—laying out a roadmap for scaling back its bond holdings by US$95 billion a month.
The moves from the Federal Reserve and geopolitical uncertainty following events in Ukraine have driven an uplift in interest costs for high yield bonds and leveraged loans.
According to Debtwire Par, original issue discounts (OIDs) 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.
Investors still have cash to deploy but, with the Federal Reserve pulling back liquidity from the market and increasing rates, the direction of travel is firmly toward a higher cost of capital for borrowers.
Lenders and investors may secure higher pricing when backing new credits, but the borrower-friendly covenant-lite documentation that characterized deals through the red-hot run of issuance in 2021 may remain a feature of the market.
Financial sponsors have grown accustomed to covenant-lite terms, generous grower baskets and a degree of flexibility around unrestricted subsidiary structures and are likely to continue securing financing along similar lines.
Investors will remain focused on securing higher pricing as they adjust to the shifting risk backdrop, which means they will be less inclined to push back on terms.
At the same time, the quality threshold for credits and sponsors that can secure favorable documentation will be higher than ever. Credits with any wrinkles will find it difficult to lock in the same documentation as strong credits backed by blue chip sponsors.
Buyout-linked financing activity will likely be an important driver of leveraged finance issuance in the second half of the year. Private equity (PE) firms with large war chests have continued to pursue deals in the first half of the year despite the challenging macro-economic landscape. According to Bain & Co., PE dry powder has reached record levels, pressuring financial sponsors to sustain deployment despite the uncertainty of the past six months.
As a result, the market has shown a consistent appetite for buyout deal financing, even as the market overall stalled—at the end of Q1 2022, leveraged loan and high yield bond issuance for buyouts was showing significant gains, year-on-year. Buyout loan issuance, in particular, has remained steady in H1 2022, year-on-year—a remarkable achievement at a time when every other category has seen significant decline.
Demand from buyout deals is likely to keep issuance ticking over in the months ahead.
The slowdown in high yield bond and leveraged loan issuance in the first six months of 2022 opened a window of opportunity for direct lenders to fill in the gap and gain market share.
Unlike broadly syndicated leveraged loan and high yield bond markets, where loans are packaged by underwriting banks and sold down to investors, direct lenders hold credits through to maturity. This has proven highly attractive to borrowers—execution is swift and there is no syndication risk.
The growth in private debt dry powder also means that direct lenders have the financial muscle to fund jumbo credits. A rarity a few years ago, US$1 billion-plus credits funded by direct lenders are becoming increasingly common.
Pricing and covenant differences between direct lending and broadly syndicated leveraged loans are also narrowing. Direct lending finance has historically been more expensive, and covenants were tighter than broadly syndicated leveraged loan capital. Syndicated leveraged loan investors, however, are pushing for higher pricing and wider OIDs when backing loans, while some direct lenders have been willing to issue debt on covenant-lite terms for selected credits.
As pricing and terms between direct lending and broadly syndicated leveraged loans converge and the market remains choppy, direct lenders will be well placed to continue taking market share and provide a compelling alternative to syndicated loans and high yield bonds.
The issuance of environmental, social and governance (ESG)-linked debt—financing where the interest payable is tied to the delivery of ESG targets—saw a four-fold increase to US$530 billion in 2021, according to Bloomberg.
Momentum behind ESG-linked debt has built further in 2022, particularly in the US market, and is now a consistent discussion point in loan and high yield bond negotiations.
As enthusiastic as lenders and investors are about providing ESG-ratchet structures in documentation, there has been a pause to reassess how ESG key performance indicators (KPIs) are set as well as their relevance to the credit. There is also a renewed focus on how ESG performance is benchmarked and independently verified, with lenders making certain that ESG-linked facilities are credible, and that greenwashing risk is minimized.
In a still nascent market, there has been divergence around how KPIs are selected and measured, but industry bodies are stepping in to provide guidance and frameworks for lenders and borrowers to follow.
The Loan Syndications and Trading Association, for example, recently released Guidance for Green, Social, and Sustainability-Linked Loans External Reviews, a document that outlines best practice on the external review process for borrowers, lenders and third-party assessors.
As more issuers look to include ESG ratchets in borrowing documentation, guidelines around ratchets and ESG reporting will become more rigorous and standardized. Borrowers will need to do more work to take advantage of the opportunity.
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