Key points to remember
Prices will rise, but issuers will continue to seek borrower-friendly terms and documentation
Lenders and investors will pause to assess the impact of inflation and the continued rise in interest rates
Direct lenders will take advantage of the volatile environment to capture market share of heavily syndicated leveraged loans and high yield bonds
ESG opportunities will persist, but lenders will ask more questions
The first half of the year marked an inflection point for US leveraged financial markets. After a dynamic but brief post-pandemic period in 2021, the combination of soaring inflation, rising interest rates and events in Ukraine have dampened US activity. Overall leveraged loan and high-yield bond issuance for the first half of 2022 was down 19% and 76%, respectively, year-over-year.
Going into the second half of the year, lenders and borrowers will be looking for guidance on debt pricing – particularly where it will stabilize after a volatile first half – and the long-term impact of rising debt. interest rates on investors’ appetite for riskier underlyings. high quality debt.
As the market navigates through this uncertain period, the following five trends are expected to influence the shape of the market in the second half of the year.
1. Debt will get even more expensive
The era of historically low interest rates and abundant liquidity has come to an abrupt end, and borrowers will have to adjust to higher prices as a result.
Inflation in the United States has reached a 40-year high this year and the Federal Reserve has raised benchmark interest rates four times in 2022 – by 50 basis points (bps) in March and May, then by Another 75 bps in July – laying out a roadmap for scaling its bond holdings by $95 billion a month.
Actions taken by the Federal Reserve and geopolitical uncertainty following events in Ukraine led to higher interest charges for high yield bonds and leveraged loans.
According to Debtwire Par, initial issuance discounts (OIDs) averaged 48 basis points in January 2022 but jumped to 473 basis points in June as the average new loan issue price fell to 95, 27% of par.
Investors still have cash to deploy but, with the Federal Reserve pulling cash out of the market and raising rates, the direction of travel is firmly towards a higher cost of capital for borrowers.
2. Conditions will remain favorable to borrowers
Lenders and investors may fetch higher prices when backing new credit, but the borrower-friendly covenant documentation that has characterized deals throughout 2021’s scorching streak may remain an issue. market characteristic.
Financial sponsors have become accustomed to covenants, generous producer baskets and a degree of flexibility around unrestricted subsidiary structures and are likely to continue to obtain funding on similar terms.
Investors will remain focused on securing higher prices as they adjust to the changing risk environment, which means they will be less inclined to push back on conditions.
At the same time, the quality threshold of credits and sponsors that can guarantee favorable documentation will be higher than ever. Credits with wrinkles will struggle to lock down the same documentation as solid credits backed by top notch sponsors.
3. Buybacks could continue to drive issuance
Buyout financing activity is likely to be a significant driver of leveraged finance issuance in the second half of the year. Private equity (PE) firms with large war chests continued to close deals in the first half of the year despite the challenging macro landscape. According to Bain & Co., dry PE powder has reached record highs, putting pressure on financial sponsors to keep the rollout going despite the uncertainty of the past six months.
As a result, the market showed a steady appetite for buyout financing, even though the market as a whole stagnated – at the end of the first quarter of 2022, the issuance of leveraged loans and bonds to high yield for redemptions showed significant year-over-year gains. Issuance of buyout loans, in particular, was flat in the first half of 2022, year-over-year – a remarkable achievement at a time when all other categories saw a significant decline.
Demand from buyback operations should maintain the pace of issuance in the coming months.
4. Direct lenders will come to the fore
The slowdown in the issuance of high-yield bonds and leveraged loans in the first six months of 2022 has opened a window of opportunity for direct lenders to fill the gap and gain market share.
Unlike the largely syndicated leveraged loan and high-yield bond markets, where loans are packaged by underwriting banks and resold to investors, direct lenders hold the loans until maturity. This has proven to be very attractive to borrowers – execution is fast and there is no risk of syndication.
The growth of the dry powder of private debt also means that direct lenders have the financial muscle to finance giant credits. A rarity a few years ago, loans over US$1 billion funded by direct lenders are becoming increasingly common.
Price and covenant differences between direct loans and heavily syndicated leveraged loans are also narrowing. Direct loan financing has historically been more expensive and covenants tighter than heavily syndicated leveraged debt capital. Investors in syndicated leveraged loans, however, are pushing for higher prices and wider OIDs when backing loans, while some direct lenders have been willing to issue debt on lightened terms for some loans. .
As prices and terms between direct loans and heavily syndicated leveraged loans converge and the market remains choppy, direct lenders will be well positioned to continue to take market share and offer a compelling alternative to syndicated loans. and high yield bonds.
5. ESG issues will continue to dominate discussions, but lender scrutiny will intensify
Issuance of environmental, social and governance (ESG) related debt – financing where interest payable is tied to the achievement of ESG objectives – increased fourfold to US$530 billion in 2021, according to Bloomberg.
ESG-related debt dynamics have further strengthened in 2022, particularly in the US market, and are now a constant talking point in high-yield loan and bond negotiations.
As enthusiastic as lenders and investors are in providing ESG ratchet structures in documentation, there has been a pause to reassess how ESG key performance indicators (KPIs) are defined and their relevance to credit. There is also a renewed focus on how ESG performance is independently benchmarked and verified, with lenders ensuring that ESG-related facilities are credible and the risk of greenwashing is minimized.
In a still nascent market, there have been differences over 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 practices for external review processes for borrowers, lenders, and third party evaluators.
As more issuers seek to include ESG ratchets in loan documentation, guidelines around ESG ratchets and reporting will become more rigorous and standardized. Borrowers will have to do more work to take advantage of the opportunity.