Yields on European leveraged loans and high-yield bonds have skyrocketed in 2022 to date. In the third quarter, first-lien institutional loans yielded 8.1% on average at issue while bonds were yielding 6.8% - the highest figure since 2012. The weighted average European bond yield so far in October is 10.7% from five deals, while there is currently no equivalent loan figure as no new deals have priced this month. Primary activity is strikingly absent for this time of year. Refinancing issuance is depressed due to the relative increase in pricing, while new paper is stalling in reaction to the volatility of price movements and subdued market appetite.
Ballooning OIDs
The shift in yields is due in large part to changes to the average original issue discount (OID). The current average margin for single B loans in Europe was 470bps in 3Q22, up from an average of 397bps over the past decade. That increase pales in comparison to the jump in OID. The average issue price in 3Q22 stood at 92.2 (% of par), a 700bps leap over the 99.2 averaged over the past 10 years.
Primary OIDs have been moving wider in step with secondary bid prices, which averaged 88.8 at the end of September. Prices have also fallen due to a decrease in new collateralised loan obligation (CLO) activity. The drop in CLO demand stems from the combined effects of lower issuance overall along with more assets moving to CCC territory – a field in which CLOs are less able to play due to portfolio restrictions.
Cov-lite concerns
While covenant-lite loans were the saviour of many companies in the short recession following the pandemic’s onset in early 2020, the likely impending recession is expected to be a more drawn-out affair. This time around, fewer covenants will likely result in similar benefits for companies able to keep their head above water. But for companies that default on their debt the likely outcome of looser covenants will be a lower recovery for bond and loan holders.
In addition to covenant-lite loans, expected recoveries for senior debtholders will also be hampered by top heavy capital structures resulting from the decrease in second-lien activity in recent quarters.
While markets are bearish, pricing is wide, documentation is loose and default numbers are expected to rise, a unique investment landscape presents itself. Refinancing opportunities have evaporated, however significant potential exists for capital appreciation in both primary and secondary markets for companies that successfully navigate the coming months.
