Five factors shaping the US leveraged loan market

Fears of a downturn and peaking credit cycle have slowed activity overall, but demand from M&A and cov-lite still dominates and high yield is picking up

After a slow start to the year, US leveraged loan issuance rebounded in Q2 2019, climbing from US$227.17 billion in Q1 to US$290.67 billion in Q2. Issuance for H1 2019, however, was still materially down on the US$999.18 billion of issuance in H1 2018.

Five main factors account for recent performance and they are likely to continue to shape the market in the coming months.

1. Loans lag in the face of potential slowdown

An interest rate cut by the Federal Reserve at the end of July, the first in a decade, is expected to weigh on leveraged loan issuance through the rest of 2019 and into 2020. Investors enjoyed higher yields on loans with floating rates as the Fed rate rose, but with rates back on the agenda to support an economy weakened by escalating global trade tensions, loans look less appealing.

The expectation of a rate cut saw retail funds turn away from leveraged loans in favor of better-yielding fixed-rate assets that would not be affected. Retail withdrawals from leveraged loan funds totaled US$18.3 billion at the end of the first week of July, the thirty-third consecutive week of net outflows, according to Lipper.

Finally, refinancing and repricing activity tailed off in 2019. This accounted for 43.96% of volume in 2018 but for just 35.34% of deal flow so far this year. Wider loan spreads and lower secondary market levels have contributed to the drop.

2. Demand from M&A remains strong

Refinancing and repricing deals may be down, but M&A loan appetite has held steady and LBO issuance has ticked higher.

LBO and M&A activity has accounted for more than a quarter of issuance in H1 2019. Year-on-year LBO volume has increased from US$66.53 billion in H1 2018 to US$87.26 billion in H2 2019. M&A volume excluding LBOs has dropped from US$177.67 billion to US$101.9 billion, but M&A share of total issuance is only marginally down from 16.1% in H1 2018 to 15.02% in H2 2018.

Of the 20 largest leveraged loan deals so far in 2019, 13 have involved either an LBO, acquisition or merger. Notable deals include Brookfield Business Partners’ LBO of Johnson Controls International, and Carlyle Group’s US$5.2 billion acquisition of telecommunications provider CommScope.

Financial sponsors and corporate dealmakers continue to find buyers for their debt and have been attracted by the leverage on offer in the market. Despite the fall in issuance, leverage on new deals has ticked higher in 2019 and is above 2018 levels. Average leverage in Q1 2019 sits at 5.1x, supported by a rise in the number of deals levered at 6x and 7x or higher.

3. Cov-lite is still king—for now

Cov-lite issuance has dominated activity, with 72% of institutional loans qualifying as cov-lite in 2019. In 2013, by contrast, cov-lite’s share of the market was only 50%.

Borrowers have been in such a strong position recently that issuers can still secure cov-lite terms even though the market has cooled. The US$4.2 billion loan issued in March 2019 to fund Brookfield’s buyout of car battery maker Power Solutions from Johnson Controls, for example, was done on similar terms to the loans issued by Blackstone’s Refinitiv and KKR’s Envision Healthcare.

The Bank of England and the Federal Reserve have both expressed concerns about the dilution of investor protections in loan documentation, while the Financial Stability Board has said it will investigate the industry to assess the risks it poses.

For now, however, the market continues to favor the borrower when it comes to loan documentation. It is worth noting, however, that the cov-lite's share of the institutional market is down on 2017 (80%) and 2018 (79%) levels. Lenders are beginning to push back on terms if credits are deemed to be of insufficient quality.

4. CLOs pause for thought?

US CLO issuance reached a record US$127.4 billion in 2018, according to Debtwire. But activity tailed off sharply in December 2018, with new CLO issuance down to US$5.2 billion from US$13.4 billion in November. Numbers improved little in January 2019, when new issuance totaled US$5.2 billion. Since then, a recovery occurred. In February, new issuance came in at US$13.1 billion and in April CLO issuance hit US$15.7 billion, its highest monthly total in two years. Despite a strong April, however, H1 CLO issuance of US$66 billion is down marginally on the figure of US$68 billion for H1 2018.

Although the prospect of an interest rate cut has reduced appetite for CLOs, with a knock-on effect for volumes, CLOs have been better placed to cherry-pick the best credits now that less retail money is competing for the same deals.

For more detail, read our CLO issuance article here.

5. High yield shows signs of renewal

Although 2018 was challenging for high yield bonds, with issuance down 35% to US$168.4 billion, the market showed signs of life in the first half of 2019. US high yield bond issuance totaled US$19.73 billion during H1 2019, up nearly 10% on the US$100.63 billion of issuance in H1 2018.

High yield bonds experienced inflows of US$12 billion throughout the year to June 26, according to Lipper. This marks a reversal from a year ago. Over 2018, outflows totaled US$43.3 billion. Interest rate cuts are a primary driver of the shift. Secured bonds, where the title of an asset is passed onto bondholders by the issuer in the event of a default, have also helped to drive the rebound.

On an overall return basis, high yield bonds are up 10.16% in the year-to-date, according to DebtWire, and are outperforming leveraged loans.

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