The release of May’s policy meeting minutes from the Federal Reserve’s Open Market Committee reaffirmed expectations that costly funding conditions for leveraged companies are unlikely to ease to a significant extent any time soon.
The disinflation trend, the Fed says, is too slow. Even the recent collapses in the US banking sector and overall tightening of credit — which has prompted comparison to the Global Financial Crisis — may put little downward pressure on inflation, committee members argued, reasoning that reduced credit availability could restrain supply, and demand, in the economy.
Given that a continuing higher-rates environment or a recession — both preludes to heightened default activity — are potential remedies in this fight against inflation, we turn the spotlight to leveraged credit. LCD data show, indeed, that by some measures the leveraged credit market has retreated to levels seen around the time of the Global Financial Crisis.
1. New loan issuance plummets to 2009 lows
Tightening conditions are clearly reflected in the dramatic decline of leveraged lending via broadly syndicated loans, by the bifurcation of market access and by issuance that shows few new borrowers to the leveraged credit market.
Looking first at supply, the $31.3 billion of institutional leveraged loan issuance (excluding refinancings) this year marks a low for any comparable period since 2009 ($7.5 billion), and is running just below the $32.7 billion for the comparable period in 2008.
For some perspective, this $31.3 billion of institutional supply is in a leveraged loan market sized at $1.4 trillion. When $32.7 billion was issued to this point in 2008, the market size was just $565 billion.
This year's primary market activity has offered scant net supply from new borrowers in which to invest, with 27% of this year’s institutional supply (excluding refinancings) stemming from add-on transactions to existing deals. With fewer newly issued loans joining the index, the borrower count in the Morningstar LSTA US Leveraged Loan Index fell to 1,158 on May 31, the lowest reading in more than two years.
More broadly, institutional activity is being dominated by amend-to-extend transactions ($29.7 billion) and refinancing transactions ($56.8 billion).
For loans funding buyouts specifically, year-to-date volume of $10.9 billion is lower than any year since 2010.
Notably, in this retreat by investors, with respect to the riskier companies, only one buyout loan so far this year, courtesy of Cvent, carried a B-minus rating (at S&P Global Ratings). During the same period in 2022, 14 such transactions had launched. This 2023 activity comes as nearly 30% of loans in the Morningstar LTSA US Leveraged Loan Index are rated B-minus, a significant jump from before the pandemic, at the end of 2019, when 14% of the index was composed of borrowers rated B-minus.
Of course, private credit providers have snapped up a significant share of US LBO financing opportunities from the traditional broadly syndicated loan market, and have been increasingly active in other types of deals, including refinancings, add-ons, and other M&A activity and dividend deals.
In terms of refinancings within the broadly syndicated market, single-B borrowers are dominating the supply scene, making up more than 70% of activity so far this year, though they are paying up to do so.
2. Loan refi costs at highest since 2008
There has been plenty of refinancing activity this year, but leveraged companies with pressing refinancing needs are currently paying the highest financing costs in more than 20 years.
LCD data show the average yield commanded by investors so far this year at 9.68% exceeds full-year, and year-to-date records since the year 2000, when the respective average readings were 10.15% and 9.93%.
On a monthly basis, outside of late 2022 and 2023, higher readings are found only in April 2020 in reaction to the Covid-19 pandemic, and in 2008.
3. Loan funding costs remain around GFC highs
On the topic of higher funding costs, the average new-issue yield across all loans remained in the double digits in May at 10.39%, after hitting 10.66% in March, the highest average monthly yield paid by loan borrowers since 2009.
In bringing the year-to-date average to 10.02%, funding costs at the end of May exceeded all comparable periods going back to 2009, and full-year readings back to 2000.
For single-B rated issuance, the average yield to maturity at 10.93% in May was up from 10.44% in April, and brings the year-to-date average to 10.56%.
At the start of 2022, single-B rated companies were funding at a 5% handle, on average.
On a quarterly basis, the average new-issue yield of 10.16% paid across all loans is the highest level since Q1 2009.
In high-yield bonds, average new-issue yields of 8.44% in the year to date compares to 6.53% over the same period in 2022 and the low watermark of 5.4% in the comparable period of 2021.
In the year-to-date, the average yield at 8.44% is the most in any comparable period since 2010.
Back to normality?
In a statement emerging from the May 2023 FOMC meeting, committee participants argued that “broader sentiment rebounded” following the slowdown of nonfinancial corporate bond and leveraged loan issuance in mid-March, adding that “issuance normalized” over the intermeeting period as stress abated later in the month.
“In April, speculative grade nonfinancial bond issuance was solid,” participants added.
While sentiment certainly rebounded (as documented in secondary market performance), LCD’s new-issue data shows it is far from normal times in the speculative grade finance markets.
As mentioned, in leveraged loans, issuance outside of refinancings is at 2009 lows.
In high-yield bonds, companies are pledging assets via secured bonds at the highest rate on record, versus unsecured issuance, and have conceded shorter funding tenors to get deals across the finishing line.
4. Unsecured high-yield bond supply at 2009 lows
Unsecured bond issuance — usually the mainstay of the high-yield bond market — is running at the slowest pace since 2009. LCD has tracked just $27.6 billion of unsecured high-yield bond issuance in 2023. That's down from $47 billion in 2022 and $163.5 billion in 2021 on the same YTD basis.
5. Secured high-yield issuance share at all-time highs
High-yield bond issuers increasingly are pledging assets in the traditionally unsecured market. the secured portion of high-yield volume so far this year, at 64%, is higher than any comparable period on record.
Meanwhile, the share of deals with longer maturities (eight years or more) is at a record low YTD, ultimately shortening the maturity runways of these companies as they navigate reduced risk tolerance.
6. Loan repayments slow to GFC levels
With financing harder to come by, funding costs soaring, and earnings down, leveraged companies are not paying down existing loans at anywhere near the pace they once did.
Only 12.85% of loans outstanding in the Morningstar LSTA US Leveraged Loan Index that were outstanding as of 12 months ago, had been repaid by the end of April 2023. That is the lowest reading since 2009.
In May, the LTM paydown rate improved slightly, to 13.23%, but remains well below where it stood a year ago, at 24%.
7. Aging like it’s 2009
Consistent with falling repayments, the loan market isn’t as young as it used to be.
A graying population by itself might not send loan default rates higher, but an impending downturn (note the Fed’s base case calls for a mild recession starting later this year) will be harder on loans that are past their prime.
After all, the older a loan, the higher its propensity to default. Historical records show that among loans to have entered the index since 1998, only 1.4% defaulted within one year of origination. By year four, this increases to 5.4%.
To that end, the weighted average age of double-B rated index loans climbed to 26.9 months in May, putting the 2023 YTD average at 25.8 months and the LTM average at 24.7 months. The May reading is oldest loan age since LCD began tracking this metric on a monthly basis in 2014 and the oldest since 2009 in comparison to full-year readings prior to 2014.
For single-B loans, where financing needs are far more urgent ahead of an expected recession, the LTM average age was 24.30 months as of May, which is the oldest loan age for this cohort since the full-year reading in 2011. The YTD average age for single-B loans stood at 25.74 months through May 31.
Of note, the LTM average age of single-B loans reached 26.05 months in April, which was the highest level since LCD began tracking this on a monthly basis in 2014. Prior to that, the next highest reading was 31.06 months in 2010.
8. Sharpe ratio most pronounced since 2008
In closing, higher yields and spreads, of course, bring higher compensation for the risk. But how does this compare to the risk-free rate?
Looking at risk-adjusted returns, the Sharpe ratio at negative -0.24 shows that the risk-free rate is greater than or is expected to be greater than loan portfolio returns.
The last time this ratio's reading was this pronounced was in 2008.
Featured image by Jakub Krechowicz/Shutterstock
This article originally appeared on PitchBook News
