Best terms for best credits as bull market bifurcates

Cov-lite terms dominate leveraged loan issuance in a market hungry for yield, but lenders are focusing on well-rated credits

The Federal Reserve cut interest rates three times in 2019, sustaining a strong appetite for yield among investors, which in turn has supported favorable supply-demand dynamics for borrowers.

The latter continue to secure debt on favorable terms, even though leveraged loan issuance has fallen during the first nine months of the year—reaching US$633.04 billion in the US by Q3 2019, down from US$1.14 trillion at the same point in 2018. The picture in Europe is similar, with issuance at US$168.79 billion by Q3 2019, down from US$203.41 billion by Q3 2018.

Around three-quarters of US institutional loan issuance in 2019 to date has been on cov-lite terms, according to Debtwire Par. In Europe, 92% of institutional loans were cov-lite, the highest proportion on record—by comparison, only 27% were cov-lite in H1 2016.

Borrower-friendly terms and documentation are now embedded in the marketplace. Features like EBITDA addbacks, where borrowers adjust profits upwards by recognizing synergies and earnings not yet realized, and most-favored-nation terms, which allow borrowers to raise additional debt under the same loan agreement, are common.

Higher floors and conservative ratios among lenders

This situation has prompted concern among some investors, who have been worried about the erosion of covenants for some time. As the Financial Times reported in July, “those looser standards are extending to the amount of time that investors must wait for basic financial updates such as an income statement or a balance sheet. Some fear that the consequent loss of transparency could deprive investors of early warnings of trouble ahead.”

As a result, credit quality is coming to the fore. Many lenders will now accept fewer protections and write debt on cov-lite terms, but only for higher quality credits. Data from Debtwire Par shows loans rated BB- or above, for example, accounted for 47% of US institutional issuance by Q3 2019, up from 38% in Q2 2019 and 20% in Q1 2019. Lower rated loans have struggled to gain any traction at all.

In the US, lenders are also asking for, and starting to get, higher LIBOR floors, which specify a minimum interest rate that borrowers must meet when rates are falling. Although the majority of credits in the US at the end of Q3 still had a 0% LIBOR floor, according to Debtwire Par, the share of loans with a floor of 1% and 0.75% climbed to 24% and 11% respectively in Q3, up from 10% and 4% in the previous quarter.

It is also worth noting that leverage in the US remains at relatively conservative levels, with financial sponsors in particular choosing to invest in and maintain equity cushions. Ratios for total leverage to adjusted EBITDA reached 5.2x in Q3 2019, only marginally higher than the 5x ratio recorded in 2017 and 2018, and a long way off the levels seen pre-financial crisis. LBO leverage trended slightly down to 5.9x in Q3 2019, from 6x levels in 2018.

With respect to distribution of total leverage, less than a third of issuance in the US is to deals levered at 6x or more, according to Debtwire Par. Close to half of LBO issuance is levered at 6x or less.

Borrowers hold the cards, but lenders set the standard

General macroeconomic and global trade developments will influence leveraged loan issuance for the rest of 2019 and into 2020, but demand remains steady and interest rates are low. This indicates that the market will remain broadly favorable to borrowers, but lenders are setting the bar higher on credit quality. They are also in a position to decline funding or negotiate tighter terms and covenants when the credits fall short of the requisite standard they seek.

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