US leveraged loan and high yield bond markets saw significant declines in issuance in 2022, as macroeconomic and geopolitical uncertainty drove up borrowing costs, dampened risk appetite and significantly reduced M&A activity.
Leveraged loan issuance came in at US$1.1 trillion in 2022, down 24% from the US$1.4 trillion achieved in the bull market of 2021. High yield activity suffered an even steeper decline, with 2022 issuance dropping to US$96.5 billion, 78% lower than the US$429.7 billion posted in 2021.
Inflation and interest rate hikes take toll
Soaring inflation and rising interest rates had a direct impact on leveraged finance markets, with a rapid decline in new issuance the likes of which has not been observed since the 2008 financial crisis.
After a steady stream of hikes throughout the year, the benchmark interest rate climbed again in December to end 2022 in the 4.25% to 4.5% range—the highest levels observed in 15 years—as the US Federal Reserve moved aggressively to keep a lid on the worst inflation the US has seen since the 1980s.
Rising interest rates saw borrowing costs soar in 2022, with the weighted average margin on institutional loans in the primary market peaking at 4.97% by Q3 before dropping down to 4.24% by year end (compared to less than 4% at the start of 2022), according to Debtwire Par.
Higher borrowing costs also halted opportunistic refinancings that represented a significant percentage of market activity in 2021 and deterred new issuers from coming to market unless absolutely necessary. Investor appetite for refinancings and new deals also faltered, with lenders preferring to buy existing paper at deep discounts to par instead of supporting the scarce supply of new deals.
According to Debtwire Par, leveraged loans in the secondary market were, on average, trading at 91.49% to par by the end of 2022, versus 97.72% at the start of 2022. In the high yield market, yields in the secondary market, on average, soared from 4.42% in January 2022 to 8.4% in December after reaching as high as 9.5% in October.
LBO and M&A issuance slides
Higher borrowing costs and bargain prices in secondary markets combined to reduce the appetite for M&A and buyout issuances, denting year-on-year numbers as dealmakers held back from pursuing new deals to assess the fallout from wider macroeconomic uncertainty.
As the year progressed, private equity dealmakers, in particular, found it increasingly difficult to obtain financing for deals, as underwriting banks virtually closed shop after taking some large writedowns on loans they were unable to syndicate to investors. According to Bloomberg, banks are still sitting on nearly US$40 billion in these “hung deals,” jamming up their balance sheets and limiting their appetite to underwrite new deals.
The lack of activity in syndicated loan and high yield bond markets, however, created an opportunity for direct lenders to fill the gap and win jumbo deals that would otherwise have been financed in the institutional markets. Examples include a consortium of direct lenders led by Blackstone Credit providing US$5 billion to finance the buyout of software company Zendesk and a US$4.5 billion package provided by Blackstone Credit and Ares, among others, to finance a deal for Information Resources.
Some direct lenders also moved opportunistically by looking to buy up debt that banks were struggling to syndicate. Private market manager Apollo, for example, has raised north of US$2 billion to purchase debt that banks have been unable to syndicate to institutional investors.
Light at the end of the tunnel
Moving into 2023, market conditions remain challenging. The Federal Reserve has signaled that further rate hikes are on the horizon with no cuts expected until 2024 at the earliest. US economic growth is forecast to be tepid and M&A markets remain moribund.
Sustained high interest rates are also expected to start impacting existing credits, with the risk of default and distress intensifying. According to Fitch Ratings, the prospect for defaults in the US is mounting, with the ratings agency expecting institutional loan defaults to land in the 2% to 3% range and high yield bond defaults in the 2.5% and 3.5% range.
There are, however, some early signs of general market recovery emerging. In January, the US Bureau of Labor Statistics reported that inflation was 6.5% in December. Although still higher than the Federal Reserve’s 2% target, the December figure marked the sixth consecutive monthly decline and the lowest level recorded since October 2021.
Slowing inflation seemed to be a factor in improving investor appetite in the syndicated loan and high yield bond markets at the end of 2022. Leveraged finance activity rallied somewhat in December, with a cluster of deals crossing the line. Pricing also showed signs of improving in Q4 2022, with loan borrowing costs easing from the peak recorded in Q3.
Turbulence may still lie ahead, and, after a difficult 12 months, lenders and borrowers are hoping for calmer waters after the storm.