Macro headwinds dampen loan activity

Stubborn inflation, ongoing interest rate hikes and the banking crisis in the US and Europe have slowed activity across global loan markets at the start of the year, but there are signs that loan issuance may start rebounding in the months ahead

Turmoil in Western banking markets, persistent inflation and continual interest rate increases by central banks have resulted in lower levels of leveraged loan issuance across global markets in Q1 2023.

In the US, leveraged loan issuance came in at US$211.5 billion in Q1 2023, down 23% year-on-year from the US$273.3 billion posted in the first quarter of 2022. In Western and Southern Europe, year-on-year declines were even steeper with issuance in Q1 2023 totaling US$24.9 billion—down 58% on the US$58.7 billion recorded during the same period in 2022.

Activity in Asia-Pacific (APAC, excl. Japan), meanwhile, was similarly challenged as leveraged and non-leveraged loan issuance slumped 46% year-on-year, from US$75.2 billion in Q1 2022 to US$40.5 billion during the first three months of 2023.

Bank distress hits home

In the US and Europe, disruptive market events in the banking sector have taken a toll on leveraged loan issuance. The US saw its biggest bank failure since the 2008 financial crisis as regulators seized the deposits of Silicon Valley Bank—a key lender to start-ups and venture capital firms—after it suffered a bank run when it unexpectedly announced it had to raise US$2.25 billion to shore up its balance sheet.

It was the first bank failure in what some analysts thought would be a string of regional banking failures. California-based First Republic Bank was subsequently sold to JPMorgan Chase in a rescue deal orchestrated by regulators and shares in PacWest and Western Alliance both came under severe pressure.

Meanwhile, in Europe, Switzerland’s largest bank, UBS, agreed to acquire distressed rival Credit Suisse in a rescue deal deemed essential to stabilize financial markets and limit the risk of contagion.

In response to these events, investors and lenders have flocked to safer assets, either stepping away from the non-investment grade loan market altogether or focusing allocations on the less risky, better protected pro rata tranches of leveraged loans.

For example, in the US, pro rata issuance accounts for almost two-thirds (65%) of the total issuance in Q1 2023. In the bull market of 2021, by contrast, institutional issuance was ahead of pro rata activity in every quarter that year.

The institutional market fared better in Western and Southern Europe in Q1 2023, accounting for more than two-thirds of the issuance and moving ahead of pro rata issuance for the first time in a year. By volume, however, pro rata loans performed well, representing more than two-thirds (68%) of European leveraged loan tranches.

Interest rate pressures remain

In addition to a stressed banking sector, Western lenders and borrowers were also contending with ongoing inflation and additional rounds of interest rate hikes by central banks during the first three months of this year.

In March 2023, the US Federal Reserve raised interest rates by 0.25%, the ninth increase since March 2022. That same month, the Bank of England also raised rates by 0.25%, responding to a surprise increase in inflation, while the European Central Bank announced its own 0.50% increase.

Rising interest rates have increased borrowing costs, deterring borrowers from raising new financing and putting the brakes on opportunistic refinancing.

In the US, average margins on first lien institutional loans came in at 4.01% for Q1 2023. While this is an improvement on the 4.19% registered in Q4 2022, prices remain elevated when compared to the sub-4% margins on offer in the bull market of 2021.

European markets have followed a similar pattern, with margins in Q1 2023 coming in at 4.93%—again, an improvement on Q3 2022 margins of 5.26% when pricing peaked in the region, but still significantly higher than the margins available to borrowers in 2021.

Lenders and investors have also focused on secondary debt markets, where existing loans have traded at deep discounts to par and have presented a more compelling value proposition than backing new loans. In the US secondary markets, loans traded at discounts between 7% and 8% in Q1 2023, while the bid price of secondary institutional loans in Europe dropped from 93.3% to 92.8% of par in March alone.

Interest rate and inflationary pressures were less pronounced in APAC, with China—the region’s biggest jurisdiction—leaving benchmark rates unchanged in March 2023. APAC loan markets have nevertheless felt the reverberations of interest rate hikes in the US and Europe, which have contributed to the slowdown in syndicated loan issuance across the region. Rather than tapping international syndicated loan markets, many APAC borrowers have opted to finance onshore, where borrowing costs are lower.

Green shoots

Despite the stiff headwinds being encountered by loan markets, there are signs that conditions may improve through the rest of the year. The Federal Reserve is widely expected to pause rate hikes at some point this year and inflation in Europe has started to slow, providing central banks with more wiggle room to keep rates stable.

Loan pricing, although still elevated, has now started to ease from the exceptional highs observed in 2022, which may help to bring more borrowers back to the market.

There is also evidence that lenders and investors are still open for business, even though overall issuance is down. Ineos Quattro and Breitling, for example, both secured dividend recaps, while Tricor inked a US$1.6 billion cross-border loan to finance a merger with Vistra. These loans, while priced lower than initial guidance, indicate that investors’ appetite for new loans is still there. In the APAC market, meanwhile, Squadron Energy secured a US$1.42 billion five-year loan to finance the purchase of CWP Renewables.

After a rough ride, leveraged loan markets are starting to see some green shoots in the near future.

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