Friday, December 9

Leveraged Finance: Where We Are and How We Got Here

By Edward Ding

(Featured image: creative common license)

It would be an understatement to say that corporate debt is important. From Coca-Cola to
Twitter, corporations are frequent borrowers that use bonds and loans to fund a wide range of difference business activities. Much of this debt financing occurs on the public markets, where investors supply capital in exchange for portions of debt. Leveraged finance, which refers to corporate debt rated at below investment grade (i.e., high-yield debt, “junk bonds”), constitutes a relatively riskier but still vital portion of these markets. By looking deeper into the present state of leveraged finance, we can gain some important insights into the financial landscape and markets as a whole.

2021 was an outstanding year for capital markets; leveraged finance was no exception. Annual issuance volume reached all-time highs for both leveraged loans (floating-rate debt) and high-yield bonds. In 2022, however, market activity has slowed precipitously. In the first half of the year, high-yield bonds suffered from an over 75 percent decline in issuance volume. Leveraged loans, whose floating rates are better suited for a rising-rate environment, have seen a much smaller 19-percent decline in volume, but the entire high-yield debt market is operating in the face of economic uncertainty, fickle investor demand, and growing issuer caution.

Given the stark change in market conditions since 2021, an obvious question presents itself: how did we get here? A broad overview of the macro situation can give us an answer.

Though a number of factors can be blamed for the leveraged finance slowdown, inflation is arguably the most salient, having cut into corporate margins and cratered consumer confidence. When faced with rising input costs (e.g., production goods, wage), companies have been forced to choose between absorbing higher expenses, which reduces their profit, or passing them on to consumers in the form of higher retail prices. Additionally, as inflation makes its mark on everything from gasoline to meat, consumers can’t help feeling that the economy is only getting worse. Inflation’s most significant consequence, however, has been a harsh monetary policy response. In committing itself to combating inflation, the Federal Reserve has set a hawkish agenda that has naturally resulted in large and sustained interest rate hikes.

An inflationary, rising-rate environment bodes ill for debt markets, especially leveraged finance. When the benchmark interest rate (i.e., the federal funds rate) increases, so do investor expectations for the return on debt investments. Macro factors also have a more severe impact on high-yield bonds than investment-grade ones. When the outlook for the economy and for corporate earnings become murkier, as they have this year, investors tend to view lower-rated companies as being the most vulnerable to default. As such, rising rates and a shaky economy, inflation being the root of both, have led to concerningly high borrowing costs for leveraged issuers.

In the face of this adverse environment, many issuers have chosen to wait and see, delaying any new debt offerings until they see improvement in the markets. On the other hand, those companies that have gone through with deals often get burned. In June, high-yield bonds issued for the buyout of packaging company Intertape Polymer Group were sold with an original issue discount (OID) of 82 cents on the dollar. That is to say, Intertape was only able to sell its bonds after marking them down by 18 percent. For context, average OID on high-yield bonds are usually in the upper 90s during ordinary years. Many deals that followed Intertape’s have been similarly troubled; a September deal for Citrix sold bonds at an 84 OID, while a recent offering from analytics firm Nielsen has seen weak demand. If there is a light at the end of the ‘22 tunnel, it has yet to come.

Weakness in the high-yield markets should not be seen as a niche concern only relevant to specialists: it can have a definite impact on the broader finance industry and broader markets. Take, for instance, private credit. As rising rates have stalled public markets, private credit firms, which specialize in direct lending to corporate borrowers, have become increasingly prominent players in the world of debt; issuers that once relied on public markets for debt financing are now more likely to turn to Apollo, Ares, and other private credit groups for loans. Meanwhile, a sluggish debt market has already proved to be a problem for investment banks, which may soon realize losses amounting to hundreds of millions of dollars on discounted deals like Citrix. Lastly, the possibility of a high-yield default wave, which some bearish analysts have predicted, would have clear knock-on effects on investor confidence across markets. For anyone involved or interested in finance and financial markets, keeping an eye on leveraged finance is worthwhile.