Our views on changing dynamics in energy, ESG, finance, globalization and US policy.
HEADLINES
- In the US, leveraged loan issuance for 2021 reached US$1.4 trillion, a 63% increase year-on-year
- The high yield bond market in the US was relatively flat, rising from US$428.3 billion in 2020 to US$429.7 billion in 2021
- In comparison, in 2021, the leveraged loan market in Western and Southern Europe increased by 28% year-on-year to €289.7 billion
- The region's high yield bond market during that period was up 47% year-on-year to €148 billion
63%
The increase in leveraged loan issuance in the US in 2021, year-on-year—in Western and Southern Europe, it rose by 28%
After moving broadly in lockstep through the past 12 months, differences are emerging between the US and European leveraged finance markets moving into 2022.
Both jurisdictions saw year-on-year growth in leveraged loan and high yield bond issuance in 2021 but, with inflation tracking higher, a divergent monetary policy response stands as a key departure point for the two markets, with implications for leveraged finance activity.
The US Federal Reserve will almost certainly raise interest rates at some point in 2022.1 In December 2021, the Chair of the US Federal Reserve, Jerome Powell, made it clear that the Fed will end its bond-buying programme in March 2022, rather than in June as originally planned, thus opening the door to lift interest rates from near zero.2
In the UK, however, the Monetary Policy Committee voted to increase interest rates from 0.1% to 0.25% in December 2021. Whether there will be more rate rises in 2022 remains to be seen. One issue for the MPC seems to be the potential impact of the Omicron variant.3 Until there is more data, the committee may feel compelled to hold off on any further rate rises in the short term.
European Central Bank (ECB) President Christine Lagarde, by contrast, has said it is 'very unlikely' that the ECB will up rates in 2022.4
If the US does raise rates in 2022 and Europe does not, leveraged finance patterns in the two markets could diverge. In a higher US rate environment, lender appetite for floating-rate leveraged loans could be greater in America than in Europe, while European lenders may find fixed-rate bond products more attractive if the ECB leaves rates unchanged. Higher rates could also impact the ability of US borrowers to service debt, although this will be dependent on the size of any rate increases.
SOFR versus SONIA
A gap between the US and Europe is also emerging, as global financial markets transition away from the LIBOR interest rate benchmark to an alternative overnight borrowing rate.
Writing in the Financial Times at the end of 2021, Tal Reback (who heads up the global LIBOR transition programme for KKR), noted that LIBOR's successor SONIA (the Sterling Overnight Index Average) had seen significant adoption in Europe, but the take-up of the US's LIBOR alternative, the Secured Overnight Financing Rate (SOFR), has been sluggish.5
UK and European regulators compelled the market to stop entering into new LIBOR-linked deals after March 2021, smoothing the transition for market participants. In the US, however, significant SOFR transfer risk remains. According to S&P, at the start of October 2021, only 14,173 US loans issued had been documented using SOFR, posing material risks for issuers and investors as the liquidity of LIBOR-linked debt products becomes harder to predict as LIBOR phases out.6
The US is also weighing up whether to apply forward-looking term SOFR. Unlike benchmarks such as SONIA, which are backward-looking and based on prior-day interest rates, forward-looking SOFR is linked to interest rate predictions in derivatives markets.
If term SOFR is adopted across the US, it will be interesting to see whether the trend migrates to the EU and whether European CFOs and treasurers fall into line with their peers in the larger US market and look for a SONIA term rate in the European debt markets.
Closing the ESG gap
The US and Europe have also moved at different speeds when it comes to ESG-linked debt issuance.
According to analysis from McKinsey, Europe's asset management industry has more funds that can be considered sustainable than any other jurisdiction, with the region's ESG bond volume double that of the US and Asia combined.7 According to Bloomberg, meanwhile, a fifth of the debt raised by European issuers in 2021 was linked to ESG initiatives—several times higher than proportions in the US.8
In the first year of President Joe Biden's administration, the US has made firm pledges and investment towards reaching net zero carbon emissions by 2050. This will give much needed impetus to ESG-linked debt issuance as the US tries to make up for lost ground—ratings agency Fitch has called for the introduction of legislation in the US to accelerate sustainability-linked debt issuance.
Across the pond, meanwhile, the EU's Sustainable Finance Disclosure Regulation (SFDR)—which lays out tightly defined criteria for what qualifies as an environmental and social asset—is already gaining widespread uptake from fund managers and investors.
It remains to be seen whether US managers will start defaulting to SFDR-linked benchmarks, or whether a dual-track system for overseeing ESG debt issuance emerges in the event of US regulators implementing their own regime.
View full image: US versus Europe: Leveraged loan issuance by value (2017—2021) (PDF)
View full image: US versus Europe: High yield bond issuance by value (2017—2021) (PDF)
Pricing and terms distinctions
In addition to moving on distinctive tracks with respect to interest rates, ESG and LIBOR, pricing and documentation trends have also diverged.
Loan documentation has been generally aligned, but in the high yield market, European documents continue to be more 'bespoke' than their US counterparts and frequently include more aggressive terms, offering more flexibility to sponsors and borrowers, particularly recently around asset sales and dividends.
Pricing trends have also begun to trend in different directions, with loan and bond pricing in the highly competitive US market dropping through the year while European prices moved higher. Margins have stayed within similar bands in both jurisdictions but, after a surge in European COVID-19 cases through the late summer and into early autumn, a more cautious lender approach and rising number of flexes in syndications have pushed prices upwards.
In addition, US leveraged finance activity has been characterised by a higher volume of jumbo deals than in Europe. According to S&P, the largest buyout syndication in the US in 2021 saw Medline secure a US$14.32 billion loan and bond package to fund its buyout, while in Europe the largest buyout syndication only totalled €3.75 billion for a loan and bond offering to fund the purchase of T-Mobile Netherlands.9
European markets, however, could see mega-deal volumes catch up with the US in 2022, from the £5.4 billion debt financing for the take-private of supermarket chain Morrisons to the potential buyouts of BT and Telecom Italia, should those deals progress.
The impact of electronic trading
The US has also forged ahead of Europe in the uptake of electronic bond trading and adopted protocols that support higher trading volumes and liquidity.
According to a study by Coalition Greenwich, an analytics and benchmarking platform, electronic investment-grade and high yield trading in the US climbed by more than 100% between 2017 and 2020, more than a third faster than the 61% growth rate in Europe.10
The study put the difference down to a willingness in the US to accept anonymous request-for-quote trades and all-for-all trading, which allows buy- and sell-side traders to transact with asset managers anonymously, regardless of their firm type.
Over the long-term, however, the liquidity advantages of these protocols are expected to gain more traction in Europe and see the two markets move closer together.
Differences aside, when it comes to securing maximum liquidity and the most-efficient deal execution, European and US markets are always likely to be aligned.
1 "U.S. to start raising interest rates from Sept 2022 - JP Morgan". 13 Dec 2021. Reuters.
2 "Fed to pivot on inflation fears in the face of another uncertain year". Lindsay Dunsmuir. 13 Dec 2021. Reuters.
3 "Headwinds for GBP as Bank of England rate decision looms". Neil Dennis. 14 December 2021. Capital.com.
4 "ECB 'very unlikely' to raise rates in 2022, Lagarde says". 3 November 2021. Reuters.
5 "Why US companies need to stop using Libor right now". Tal Reback. 30 Nov 30 2021. The Financial Times.
6 Ibid
7 "European asset management after an unprecedented year". Sid Azad, Pierre-Ignace Bernard, Cristina Catania, Martin Huber, Niklas Nolzen, and Christian Zahn. 4 July 2021. McKinsey. See full report, page 10.
8 "Europe Trounces U.S., Asia in Race to Turn Capital Markets Green". Jacqueline Poh (Bloomberg News). 15 July 2021. Bloomberg Law.
9 "LCD News Today, Europe: Dec. 14, 2021". David Cox. 14 December 2021. S&P Global.
10 "US outpaces Europe in electronic bond trading growth, report finds". Annabel Smith. 14 July 2021. The Trade.
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