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?
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
Lenders and borrowers in US leveraged finance markets have had to recalibrate pricing and issuance volume expectations in 2022 in the face of rising inflation and interest rates.
The abundant liquidity that stoked red hot leveraged loan and high yield bond markets in 2021 dried up through the first half of 2022, as macro-economic uncertainty, events in Ukraine, soaring energy prices and-COVID-19 supply chain bottlenecks drove up prices for goods and services and left central banks worldwide with limited alternatives to maintain low interest rates.
US Labor Department figures showed inflation for consumer goods rising by 8.5 percent in March, representing the largest year-on-year increase since 1981. In response, that same month, the US Federal Reserve raised interest rates for the first time in three years to fight inflation, upping rates by 0.25 percentage points.
At the beginning of May, the Fed proceeded with a 0.5 percentage point increase and in June, as inflation reached a 40-year high, interest rates were increased by another 0.75 percentage points—the largest hike since 1994. By July, with inflation remaining stubbornly high, the Fed raised rates once again by 0.75 percentage points.
Further rate increases are in the pipeline, with liquidity also expected to tighten as the US Central Bank scales back its US$9 trillion balance sheet.
2.25%
Since January, the US Federal Reserve has raised interest rates four times, taking its benchmark funds rate to a range of 2.25 – 2.5 percent
The impact of climbing interest rates and inflation on US leveraged finance markets has been most keenly felt in the high yield bond space.
As fixed rate instruments, high yield bonds are vulnerable to rate hikes, which eat into bond investor returns. This has resulted in material amounts of capital being pulled out of high yield bonds—data from Lipper shows that, in the first four months of the year, US$27 billion flowed out of the asset class.
This has resulted in a challenging market for issuers. According to Debtwire Par, high yield bond issuance was down 76 percent in H1 2022, year-on-year, to US$63.6 billion.
High yield bond issuers that have come to market have paid higher rates to convince investors to back their offers. Used car retailer Carvana, for example, paid a 10.25 percent coupon to land a US$3.27 billion unsecured eight-year bond in April to fund the acquisition of ADESA’s physical auction business. By comparison, eight months earlier, in August 2021, Carvana had tapped the market for an unsecured eight-year bond priced at 4.875 percent.
Dallas-based glass and glazing manufacturer Oldcastle, meanwhile, paid a 9.5 percent coupon and offered a discounted issue price (92.12 percent) to investors on a US$585 million secured bond used to fund a portion of its leveraged buyout by KPS Capital Partners.
Carvana and Oldcastle both received ratings in the lowest bracket (CCC+ or lower) and, in a market characterized by thin volumes, accounted for more than half of monthly issuance in April. As a result of these two bond issues, average yields on senior secured and unsecured bonds spiked from 5.71 percent in Q1 2022 to 8.07 percent in Q2, according to Debtwire Par.
Even higher-rated credits have been affected by the volatile inflationary environment. BB-rated engineering and construction company Global Infrastructure Solutions, for example, priced a ten-year US$300 million senior unsecured note at 7.5 percent and par, but has seen pricing in the secondary market drop to 88.7 percent of par, for an implied yield of 9.25 percent.
The leveraged loan market has been shielded from macro-economic headwinds to a degree, as the floating rate structures on loans rise in line with increasing interest rates, but it has not been immune.
The leveraged loan market has been shielded from macro-economic headwinds to a degree, as the floating rate structures on loans rise in line with increasing interest rates, but it has not been immune from the impact of these market fluctuations.
Up to May 2022, leveraged loan funds had enjoyed a run of 18 months of consecutive growth in assets under management, according to S&P and Lipper. From the beginning of May to the end of the week ending June 22, however, more than US$6 billion has exited the market as investors have become more risk-averse.
Activity in the collateralized loan obligation (CLO) space—the largest pool of investors in leveraged loans—has also eased, particularly in refinancings. New CLO issuance is down 12 percent year-on-year for the year to the end of May 2022, while CLO refinancing issuance has dropped by 94 percent. This may pivot again as and when things improve, however, as CLOs have proven to be resilient throughout the worst of the pandemic to date.
With demand for loans tightening, loan prices have moved higher. According to Debtwire Par, average margins on first-lien institutional term loans climbed to 4.31 percent in Q2 2022, well above the Q1 2021 average of 3.96 percent and the 3.74 percent average recorded in Q2 2021.
Despite some bleak headlines, the market is still open for business—Refresco Gerber raised a US$4.1 billion-equivalent multi-currency loan package to back its buyout by KKR, while Therm-O-Disc secured a US$360 million term loan B for its buyout by One Rock Capital Partners. While the loan space will no doubt recover its momentum in the months to come, interest rates and inflation are resetting market expectations.
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