Despite extreme volatility and uncertainty, US leveraged loan and high yield bond markets proved resilient in the face of COVID-19 disruption and are well-positioned for a year of steady issuance.
Low interest rates and the search for higher yields by lenders as they deploy their capital are expected to drive leveraged loan and high yield bond activity. US stocks are hitting record highs and the roll-out of COVID-19 vaccination programs offer a stable backdrop for capital markets, which will provide momentum for issuance in 2021.
For borrowers with solid credit quality—particularly in sectors that have performed well through the pandemic, such as technology and healthcare—borrower-friendly documentation and covenant packages are expected to remain a feature of the market, as lenders search for opportunities while minimizing risks.
Businesses that were fundamentally secure pre-COVID-19, but directly impacted by the pandemic, such as those in the travel, aviation and leisure sectors, may also buoy activity with further issuances at price levels well in excess of those seen pre-COVID-19.
Navigating uncertainty
This broadly positive outlook follows an undeniably disruptive year. After a steady start to 2020, US leveraged loan issuance more than halved in Q2 2020, falling from US$329.7 billion in Q1 2020 to US$148.5 billion in Q2, according to Debtwire Par, as lockdown restrictions stalled activity.
The contraction in institutional loan issuance was even more stark over this period, falling almost 70% between the first two quarters of the year.
By the final quarter of 2020, however, issuance had rebounded. Overall leveraged loan issuance reached US$219.6 billion in Q4, with institutional issuance also gaining ground over the final three months of the year. The late rally to close the year limited the fall in annual leveraged loan issuance to around 5%, year-on-year, with institutional issuance up 10% by year end despite the slowdown in April and May.
High yield bond markets, by contrast, made a strong showing in 2020, winning market share from the loan space. High yield bond issuance came in at US$428.3 billion for the year—higher than any 12-month period in the past five years and 69% up on the US$253.2 billion figure recorded in 2019.
A combination of factors supported this jump in high yield activity, including the Federal Reserve’s decision to buy bonds issued by so-called “fallen angels”—credits downgraded from investment grade to non-investment grade—and the strategic decision by some borrowers to refinance loans subject to ongoing maintenance covenants with high yield bonds, which are only subject to incurrence covenants.
The underlying credit quality of fallen angels, meanwhile, appealed to high yield lenders searching for yield, encouraging investment.
The contrast between activity levels in leveraged loan and high yield markets through the dislocation period can also be explained by the position of the banks underwriting and syndicating loans.
When the first round of lockdowns took effect, borrowers moved swiftly to lock in liquidity and drew down extensively on existing credit lines and revolving credit facilities (RCFs) held with their banks. According to S&P, more than US$222 billion was drawn from 414 RCFs in March and April—under normal circumstances, these facilities would be only partially drawn.
Going into 2021, both high yield and leveraged loan participants expect the momentum from Q4 2020 to carry into the new year. If 2021 progresses without the level of disruption seen in 2020, prospects for rising year-on-year issuance are promising.
M&A activity boost
Rebounding M&A markets are expected to give leveraged finance activity an additional lift.
M&A leveraged loan issuance and LBO leveraged loan issuance in 2020 declined year-on-year by 14% and 33%, respectively, as M&A dealmakers put new transactions on hold to focus on stewarding existing portfolios through the initial period of COVID-19 uncertainty.
This pause in dealmaking saw US M&A deal value fall from US$1.6 trillion in 2019 to US$1.3 trillion in 2020. Reduced M&A opportunities and a focus on liquidity among borrowers during Q2 meant that most loans and bonds were raised for general corporate purposes and repricing.
M&A activity, however, rebounded strongly in H2 2020. US deal value increased almost six-fold from Q2 to Q3 and the Q4 deal value total of US$544.2 billion represented the second-highest quarterly deal value of the past decade.
Leveraged loan issuance for M&A in the US recovered strongly after June 2020 as deal activity picked up. A sustained rise in M&A activity in 2021 will drive a corresponding uptick in M&A and LBO leveraged finance issuance, with consistent lender appetite expected for new M&A deals backed by sponsors.
A 64% year-on-year rise in dividend recap volume to US$32.9 billion in 2020 served as another indicator of lender appetite for new deals.
In high yield bond markets, meanwhile, refinancing, repricings and amendments accounted for the bulk of issuance (US$283.1 billion), with lenders like hotel chain Hilton Worldwide coming to market to replace existing notes and extend debt maturities.
Terms and pricing
Despite pandemic uncertainty, borrowers of high credit quality were able to continue securing favorable terms and loan documentation in line with what was available in the borrower-friendly, pre-COVID-19 market. By Q4 2020, following the market recovery in the second half of the year, higher leveraged credits were also securing similar terms. Cov-lite loans accounted for 84% of institutional loan issuance in 2020, a higher share than in any year going back to 2013, according to Debtwire Par.
Pricing levels have also shown signs of moving back in favor of borrowers, although lenders did secure higher pricing for loans and bonds immediately after the first round of lockdowns.
The average yield on first lien institutional loans widened from 303bps in Q1 2020 to 488bps in Q2, although prices have moved in the opposite direction since, sliding to 424bps and 417bps in Q3 and Q4, respectively, as markets reopened and competition among lenders increased.
Similar patterns played out with respect to original issue discounts (OIDs)—the discount from par value at which a loan is offered for sale to investors—and LIBOR floors, which set a floor on how low LIBOR rates can be for a given deal, even if the actual LIBOR rates are lower than the floor.
OIDs came in at 97.4 in Q2 2020, according to Debtwire Par, rising to 98.8 by Q4. Average LIBOR floors decreased from 97bps in Q2 2020 to 82bps in Q4 2020.
In high yield bond markets, the weighted average yield to maturity for all high yield bonds rose from 5.2% in Q1 2020 to 7% in Q2 2020, before moving back down to 5.5% by the end of 2020.
According to Debtwire Par, loans and bonds priced lower than initial guidance by December, with reverse pricing flex exercised on 47 occasions during the month, versus only 20 cases where pricing was flexed in favor of lenders.
Increasing investor appetite and robust demand from collateralized loan obligations (CLOs) are expected to keep pushing pricing tighter in 2021. CLO issuance was down 24% year-on-year, but staged a strong recovery in Q4, with issuance of US$31.5 billion according to Creditflux.
Certain lender terms hold firm
While documentation and pricing appear to be moving back in favor of borrowers, lenders are holding the line in certain areas.
Unrestricted subsidiary terms, which allow borrowers to move key assets into separate vehicles, often for the purpose of raising additional financing, are a focus for loan lenders, who are including protective provisions in documents to block “crown jewel” assets from being moved into unrestricted subsidiary structures.
Similar terms are also appearing in bond documentation, as observed with Viking Cruises, which issued a US$675 million high yield bond that included certain unrestricted subsidiary blockers.
Lenders are also paying closer attention to terms that allow a subset of lenders to elevate their credit position through “priming.” Lenders have noted developments in some deals, such as one involving apparel company Boardriders, where certain existing lenders were able to “prime” other incumbent lenders by providing new loans, and repositioning existing loans, that will rank higher in the capital structure.
In high yield bond markets, meanwhile, lender appetite appears to be skewing toward secured over unsecured bonds. Secured high yield bond issuance accounted for 39% of overall issuance in 2020—roughly 10% above the historical average of approximately 29%.
These focus areas aside, however, the drive for yield indicates that borrowers will continue to secure leveraged loan and high yield financing on attractive terms as lenders and investors look for opportunities to put money to work in a low interest rate environment.
