Debt issued in the institutional leveraged loan market is shifting back in the favor of BB facilities over B-rated tranches. So far in 2023, almost 40% of activity within these two groups has been BB rated, marking the highest percentage in the past five years for the safest assets in the sub-investment-grade space.
The bond market has followed a similar trend, with the share of debt issued as secured notes remaining at record highs of near 60% over the past three quarters. The historical average ranges between 25-45% in the past decade, highlighting the current move towards safer assets.
In both markets, leverage can be seen to be falling, with investors rushing towards safer assets, as lending on higher leverage ratios becomes unpalatable. Net leverage for 1H23 stands at 4.5x, while gross leverage is currently at 4.9x.
To compensate for their investments in these riskier assets, investors have been requiring higher yields on deals that have made it over the line so far this year. Yields on first-lien institutional loans jumped to an unprecedented 10.6% thus far in the second quarter, and the weighted average yield in the bond market stands at 8.7%. While this figure has decreased by over one percentage point from highs in 4Q22, the yield remains significantly above levels seen in recent years.
New money, new lows
Despite the prevalence of higher yields, refinancing activity continues to be a cornerstone of the current market, with high-yield bond issuance skyrocketing to USD 34bn so far in 2023 – nearly double the same period last year. Refinancing is similarly buoying the leveraged loan market, rising 16% year-on-year despite overall leveraged issuance falling 30% to just under USD 300bn in the year to date (YTD). This shows that even with the headline figure of the leveraged market appearing solid, there is a marked lack of new capital being deployed in the sector.
As a result of a lack of supply from M&A transactions, dividend recaps have started to resurface, as sponsors realise exit opportunities represent one of the few avenues available to them to achieve a return on their investment in the near term. A further USD 900m was issued for shareholder payments in April, bringing the total YTD amount to USD 3.6bn.
Considering the leveraged market in its current state, eventually something will have to give. Issuers are currently paying over the odds to refinance debt, pushing out maturities in the short term at exceptionally high interest rates, which are unsustainable over the long term. The market is in an eerie calm, with overall volumes appearing respectable. However, money being moved away from lower-rated assets, refinancing dominating issuance, and the lack of a solid M&A pipeline all point to an unsustainable market, with issuers set up to be unable to pay the higher interest rates demanded by investors for the risk taken.
If interest rates were to drop materially in the next few years to allow borrowers to refinance at manageable rates, then a material rise in defaults could be avoided. However, if the market remains in its current state, the ominous markers above suggest a difficult road ahead.
