HEADLINES

• US leverage loan issuance for 2022 fell 24 per cent, year-on-year, reaching US$1.1 trillion
• High yield bonds in the US were hit particularly hard, dropping 78 per cent during the same period to US$96.5 billion
• Leveraged loan issuance in Western and Southern Europe by comparison was down 37 per cent year-on-year for 2022, at €183.4 billion in 2022
• High yield bond activity in Western and Southern Europe dropped 66 per cent during the same period, to €50 billion

Leveraged finance markets in the US and Europe faced similar challenges over the past year, with climbing inflation, rising interest rates and deep discounts in secondary markets putting the brakes on issuance.

Deeper, more-liquid US markets weathered these headwinds better, although activity remains subdued. US leveraged loan issuance dropped 24 per cent year-on-year to US$1.1 trillion, with high yield issuance off 78 per cent over the same period. In Western and Southern Europe, by comparison, leveraged loan and high yield bond issuance fell by 37 per cent and 66 per cent, respectively.

Central banks in the US, UK and EU all lifted interest rates in 2022 to the highest levels observed since the global financial crisis, in a collective effort to curb surging inflation. The pace and scale of rate rises may diverge slightly in 2023, but central bankers in each jurisdiction have signalled that more rate rises are on the horizon, suggesting that high interest rates will continue to shape leveraged finance activity on both sides of the Atlantic for the immediate future.

Rising borrowing costs chill issuance

Higher base rates have pushed up borrowing costs across the board. In Europe, the average margins on first-lien institutional loans climbed by almost 1.5 per cent in the first nine months of 2022, reaching 4.73 per cent by year end, according to Debtwire Par. Weighted average yield to maturity for fixed rate bonds was up from 4.73 per cent at the end of 2021 to 8.23 per cent in Q4 2022.

US loan margins escalated at a similar clip, with average margins on first-lien institutional loans climbing from 3.73 per cent in the final quarter of 2021 to 4.24 per cent by the end of 2022, while the weighted average yield to maturity for US senior secured high yield bonds was up to 10.38 per cent at the end of Q4 2022, from 6.71 per cent over the first quarter.

Rising borrowing costs have chilled issuance, which has also been hampered by widening discounts in secondary markets, with investors preferring to buy up existing credits at discounts to par rather than putting money to work via new issuance. In the US, loans in the secondary market changed hands at an average of 91.49 per cent to par in December 2022, with European paper trading at 90.6 per cent in the same month.

US TLA and ABL markets soften the landing

In addition to benefitting from a larger fixed-income investor base, US borrowers have also been helped by the country's more established and sophisticated term loan A (TLA) and asset-based lending (ABL) markets.

According to Debtwire Par, TLA issuance in the US, also known as pro rata debt, was up 55 per cent year-on-year at US$765.7 billion. Unlike term loan B (TLB) debt—which underwriting banks will parcel and sell down to institutional investors, including mutual funds, insurers and CLOs—commercial banks typically fund TLAs and hold them on their balance sheet. These amortise materially over the life of the loan, unlike TLB packages, where loans are subject to only de minimus amortisation prior to maturity, and come with financial covenant protection.

These more lender-friendly characteristics give banks greater protection by providing for potential earlier warning triggers given the additional payment requirements and a financial covenant. In the red-hot debt markets of 2021, borrowers favoured the loose terms available in the TLB space but, as the institutional market has jammed up and syndication risk has intensified, borrowers have pivoted to the more predictable TLA space.

Notable deals in this space in 2022 include debt financing that combines TLA, TLB and high yield facilities for Univision Communications, a Spanish-language content and media company. The financing includes a five-year, US$500 million senior secured TLA facility and a US$500 million TLB, alongside a US$500 million senior secured high yield bond.

ABL activity has also climbed, rising 42 per cent year-on-year to US$111.8 billion. ABL debt is also provided by banks and is secured by more liquid assets (e.g., receivables and inventory), offering a better shield against swings in the credit cycle than cash flow lending, which is driven by interest rates and forecasts for borrower earnings.

View full image: US versus Europe: Leveraged loan and high yield bond issuance by value (2018—2022)

Direct lenders seize opportunity

While neither TLA or ABL activity contributed to overall lending in Europe in a meaningful way, one area where it mirrored the US is in the private debt space.

In the US and Europe, direct lenders have stepped up to fund credits that would normally have gone down the syndicated loan or high yield bond route. As take-and-hold lenders, private debt funds have provided greater certainty of execution for borrowers in volatile credit markets.

In the US, direct lenders have taken on some jumbo credits, including approximately US$5 billion in financing provided by a Blackstone-led group to fund Hellman & Friedman and Permira's leveraged buyout of software company Zendesk and Ares' and Blackstone's participation in a US$4.5 billion loan to fund an investment in Information Resources. Deals in the €1 billion-plus range in Europe have also found direct lenders open for business, including Astorg's acquisition of drug development company CordenPharma.

Individual direct lenders tapped the brakes somewhat as 2022 progressed, gradually reducing cheque sizes, but private debt players have proven adept at clubbing together to spread the risk while continuing to provide financing for transactions of scale.

In the US and Europe, direct lenders have also moved to buy un-syndicated debt from banks, often at discounts. At the end of 2022, US and European banks were sitting on more than US$40 billion in buyout debt stuck in syndication because of a more risk-averse market, according to Bloomberg. In certain of these situations, some private credit funds came in aggressively as buyers of these loans and bonds, often either taking on the entire tranche at a discount or purchasing large tickets.

For example, in Q3 2022, Los Angeles-based stressed and distressed debt investor Oaktree noted that banks were disposing of hung debt at attractive prices. New York-based private markets manager Apollo raised more than US$2 billion to buy up hung debt paper. In Europe, the direct lending arm of Pimco bought up loans used to fund the buyouts of supermarket Morrisons and payment group Worldline.

It remains to be seen whether direct lenders can defend these gains in market share when syndicated loan and high yield bond markets eventually do revive but, in the US, underwriting banks are anticipating that competition from direct lenders will become a feature of the market in the long term.

In response to the competition for financing deals from private debt, for example, J.P. Morgan has set up a division that, like direct lenders, will hold debt on its own balance sheet to maturity rather than syndicate.

In Europe, meanwhile, the direct lender will sometimes come in as an anchor investor and the remaining debt will then be sold down to more traditional participants. Some underwriting banks, however, are looking to capitalise on momentum in the direct lending space by placing debt with direct lenders rather than going down traditional institutional channels.

Hoping for green shoots… but challenges remain

Moving into 2023, lenders and borrowers in both markets will be hoping that interest rates and inflation peak by the middle of the year, bringing stability to debt prices in secondary markets and encouraging primary markets to reopen.

There are some suggestions that inflation may be peaking in the US and the UK, which will ease the pressure on central banks to up interest rates. In Europe, however, where monetary policy tightened later, it may take longer for inflation and rates to flatten out and for debt markets to spark back to life. And even if the pace of rate rises cools, restructurings and defaults are on the horizon in both jurisdictions as the rate hikes of the past 12 months start to feed through.

Hopes may be rising that conditions for new debt issuance will improve in 2023, but the next 12 months will continue to be challenging for US and European debt markets nonetheless.