Joe Biden’s election and inauguration as US President has been welcomed by US leveraged finance dealmakers, with lenders and borrowers relieved that the transition of power has concluded, and a degree of certainty has returned to markets.
US leveraged loan issuance closed 2020 down 4% on 2019 levels while high yield issuance was up 69% year-on-year, despite the steep decline in activity due to COVID-19 in Q2 2020 and the tense buildup to the Presidential election in November. The secondary market also recovered, with average loan pricing rising from a nadir of 85.68% of par in March 2020 to more than 95% at the end of the year.
The market began to rally in the early weeks of Q4 2020, but there was a pause during the lead-up to the election as uncertainty around the result intensified and the rhetoric heated up significantly. The result, however, offered a solid foundation for ongoing lending and borrowing, as well as stability in secondary pricing, which climbed month-on-month in November and December 2020.
With the election over and the new administration in place, the debt markets’ attention has turned to the President’s potential policies on leveraged finance.
The most notable developments since the January 2021 inauguration have been the appointments of former Federal Reserve chair Janet Yellen as Treasury secretary and the reemergence of Maxine Waters as the House Committee of Financial Services chair.
Yellen has expressed concerns about the amount of debt being taken on by leveraged finance and high yield borrowers for a number of years. Her particular worry has been that sub-investment grade borrowers carrying high levels of leverage are exposed to an economic slump that could force them to cut investment and jobs in large numbers.
Indeed, Yellen was a Federal Reserve governor in 2013 when the three federal banking agencies collectively moved to limit leveraged loan activity by issuing guidance limiting leverage multiples to 6x Ebitda.
Waters also publicly supported the 2013 leveraged lending guidance, and both Waters and Yellen also challenged the decision, in June 2020, to revise Volcker Rule bank regulation and allow banks to back debt funds.
The leveraged lending guidance was challenged as not having gone through the proper administrative procedure during the Trump administration. The guidance remains in place as a supervisory tool, but the potential enforcement of violations of its provisions is very uncertain. Since then, Bloomberg estimates that around 40% of leveraged lending to M&A and buyouts now exceeds the 6x debt-to-Ebitda threshold.
Much of this debt also has limited covenants. According to DebtWire Par data, 84% of US institutional loan issuance was covenant-lite in 2020. In 2013, when the leveraged finance guidance was first introduced, only half of leveraged loan deals were classified as covenant-lite.
Yellen has called for the implementation of regulatory oversight for non-bank direct lenders, who presently do not face the same regulatory obligations as banks. She has also lobbied for the passage of new legislation updating the Dodd-Frank Act, placing alternative lenders under the regulatory spotlight of the Financial Stability Oversight Council (FSOC), a regulatory panel headed by the Treasury Secretary. If this proceeds, the changes will give the FSOC new powers to oversee any entity engaging in leveraged lending.
Change will be slow
Any developments along these lines, however, won’t be in place for some time. It would take more than a year to propose and implement leverage caps, allowing for public consultation, and with the Democrats holding only the narrowest Senate majority, passing legislation will be tricky. To date, the Biden administration has not nominated a candidate to be Comptroller of the Currency to lead the OCC.
In addition, the Federal Reserve’s vice chairman for supervision, Randal Quarles, and FDIC chair Jelena McWilliams, are Trump appointees who will only see their terms expire in October 2021 and at the end of 2023, respectively. They may oppose any push for tighter regulation of debt markets during the remainder of their terms.
Yellen will, however, have regulatory levers at her disposal. As head of the FSOC, she has the authority to classify leveraged lending as a systemic risk to the financial system, which will give the Federal Reserve more scope to regulate non-bank lending activity.
A Biden administration could also see leveraged finance regulation as a lever to drive its wider climate change policy agenda.
Options open to Biden could include guidance, pricing incentives or even regulation that directs lenders to rebalance portfolios in favor of borrowers with strong environmental, social and governance (ESG) credentials. The federal banking agencies could decide to include the potential effects of climate change in their annual stress tests of banks, although they have not yet decided to do so. The administration’s focus on reducing carbon emissions could also have an indirect impact on how lenders weigh ESG factors when constructing portfolios.
As the government still grapples with the public health and economic fallout of COVID-19, leveraged finance reform is not likely to be a priority. Over time, however, as the pandemic is brought under control, we expect the administration to review the leveraged finance markets.