Looking to the second half of 2024, the rate-hike-induced M&A drought — after the Federal Reserve in March 2022 embarked on a rapid-fire monetary tightening policy that pushed interest rates to their current, 23-year highs — is expected to ease toward the end of this year. And debt investors, who have been keenly looking to deploy capital, will continue to focus on both the private credit and broadly syndicated leveraged loan markets, as borrowers weigh each of those financing options, in search of the best deals.
Key areas of focus for 2024’s second half:
- Rate cuts should encourage more M&A activity, though the timing is uncertain.
- Borrowing costs may further compress as loans remain in high demand.
- Private credit will continue to expand options for borrowers.
- While restructurings generally will trend lower, liability management transactions will make up a significant share of the restructuring landscape.
- Unsecured issuance should continue to stage a comeback in the high-yield bond segment.
What we’re watching:
1. Rates, rates, rates ...
Elevated base rates propelled the floating-rate US leveraged loan asset class to a nearly 13% return in the 12 months to May 15, with 9.8% from coupon-clipping alone. The total return is on par with a post–Global Financial Crisis high of 13% in 2023, per the Morningstar LSTA US Leveraged Loan Index.
The key question now: How much longer can investors continue to clip coupons from higher-for-longer base rates before a greater share of floating-rate loan borrowers become vulnerable to the cumulative effect of rate hikes?
Directional clues can be found in the filings of public companies, where coverage measures remain perilously thin for a wide swath of borrowers.
Among LCD’s sample of leveraged loan issuers that file results publicly (consisting of 150 issuers, representing 13% of the Morningstar LSTA US Leveraged Loan Index), cash-flow coverage of interest expense, on a weighted average basis, fell below 3x in the second half of 2023.
This is more than a turn below the post-pandemic peak of 4.18x in the third quarter of 2022.
Some 37% had cash flow coverage of less than 2x in Q4 2023, versus 23% in Q4 2022.
More concerning, 12% of the sample had a very precarious cash flow coverage of less than 1x. That share is up from 7% in the fourth quarter of 2021, before the Fed’s opening rate hike in March 2022.
Still, a thirteenth straight quarter of positive EBITDA and revenue progressions, dating to the fourth quarter of 2020, were enough to lift EBITDA coverage of interest expense to 4.34x on a straight average basis and to 3.90x on a weighted average basis in the fourth quarter, up slightly from respective post-pandemic lows of 4.26x and 3.83x in the third quarter. Those levels plunged last year, and the Q4 2023 readings remain more than a full turn lower, relative to readings of 5.55x and 4.97x, respectively, in the fourth quarter of 2022.
In addition, these metrics reflect public companies, which typically have lower leverage and higher interest coverage than their PE-backed counterparts. Looking over the last 15 years, loans issued to sponsored companies had initial interest coverage of roughly 1.5 turns lower versus non-sponsored borrowers, based on pro forma financials at the closing of the loans. In the five years leading up to the start of the Fed rate hikes, this gap was even wider, at 1.7x on average, suggesting that PE-backed borrowers will feel the pinch of higher rates more acutely.
Higher for longer
With the damage of high debt maintenance costs to interest coverage evident enough among a subclass of loan borrowers, LCD took a look at outcomes with respect to default probability.
Tracking loans that closed between 1995 and Q1 2023, and that subsequently defaulted, 13% of companies with cash flow coverage of less than 2x at issue defaulted within a year. This jumps to 21% of companies that would default between one and two years and 30% that would default between two and three years.
As things stand, better-than-expected economic growth and sticky inflation have prompted markets to readjust their expectations.
Coming into the year, the market was expecting the Fed to cut rates at least six times in 2024, beginning in March. Now, with the federal funds rate remaining at a target range of 5.25-5.50%, federal funds futures pricing indicates just two cuts, starting in September.
2. M&A slowly on the mend
Closing out 2023, US M&A had declined for two straight years, and the ramifications on the credit side were stark.
LCD data show just $70 billion of institutional term loans issued in the broadly syndicated market in 2023 backing M&A, down a staggering 79% from the $331 billion in 2021, and down 51% from an unsettled 2022 market, when $143 billion of term loans backed M&A.
On the high-yield side, the $38 billion of M&A-related issuance in 2023 fell well short of the $108 billion in 2021. However, with an increasing reliance on secured issuance, it was slightly higher than the $36 billion in 2022.
All told, broadly syndicated issuance across leveraged loans and high-yield bonds to fund M&A-related activity was down 75% from 2021.
Some green shoots are emerging, with $44 billion of leveraged loans for M&A deals priced in the broadly syndicated market through May 16, which is running at twice last year’s anemic pace. Similarly, high-yield issuance has risen nearly twofold, with $16.3 billion issued for M&A purposes.
As PitchBook’s Private Equity team explains, M&A has almost always bounced back from consecutive annual declines, and this year is expected to conform to past trends. In fact, based on LCD’s leveraged loan issuance data going back 24 years, syndicated loan volume to fund M&A has never declined in three consecutive years.
Higher borrowing costs diminish appetite for M&A dealmakers, particularly for big-ticket transactions. However, deal making is also sensitive to economic headwinds, and any signs of a sharp downturn in the economy. With that risk quickly receding, Q3 2023 marks a trough in a two-year downturn.
Looking ahead, the potential for lower rates later in 2024, contingent on moderating inflation data, instills optimism for a potential rebound in deal activity in the second half of the year. Despite the challenging sponsor exit environment, the pipeline of deals should grow in anticipation of lower rates, which will boost M&A activity in future quarters.
In addition, borrowing spreads have tightened to multi-year lows in the BSL market on the back of surging investor demand, which bodes well for restarting the M&A engine. In the second quarter thus far, the average spread of M&A-related loans has tightened to S+342, the lowest reading since Q4 2019 (S+432), down nearly 100 bps from a year ago. The corresponding new-issue yield-to-maturity, which includes the base rate, spread and original-issue discount, retreated to 9.17% in April and May, versus 10.70% a year ago and the recent peak of 11% in Q2 2022.
3. A private and public credit tug-of-war
Sponsor companies have been shifting their funding between private credit and broadly syndicated markets, though they seek options in both.
Just when participants were becoming accustomed to private credit dominating leveraged finance, and banks appeared to be in permanent retreat, the market shifted again. Beginning in late 2023, the syndicated loan segment showed signs of reopening, even for lower-rated refinancings. The trend accelerated in the first quarter of 2024.
The BSL and private credit markets often compete, especially for larger deals.
Weary of interest costs on debt placed in recent years — with unitranche loans and second-lien debt particularly burdensome — private equity-backed companies took the opportunity to shake off this high-cost financing in favor of lower-cost syndicated loans. PitchBook LCD data showed that 35 companies have issued a broadly syndicated loan to refinance $14 billion of debt previously provided by direct lenders in the year to May 15.
For private credit providers the result was a quieter time than most would like.
Among the more prominent examples, Wood Mackenzie demonstrated how worthwhile refinancing could be. The company placed a $1.315 billion covenant-lite term loan B due 2031 at S+350, with a 0% floor and an OID of 99.75, according to sources.
Proceeds from the deal refinanced a unitranche term loan due February 2030 (S+675, 0.75% floor) totaling $1.244 billion. In addition to the TLB, the company has a new $150 million revolver due 2029 with a first-lien leverage covenant.
Direct lenders, meanwhile, have gone on the offensive to protect their recently earned borrowers from refinancing debt in the syndicated market. With new-issue spreads tightening to multi-year lows in the BSL market, direct lending pricing is traveling in the same direction, especially for larger transactions. In fact, LCD News reported on at least half a dozen PE-backed direct lending deals this year with spreads below S+500, versus none in 2023. Deals at this tight end of the spread distribution tend to be larger. Excluding add-ons, the smallest deal with a sub-500 spread was $325 million (Rover Group).
Given that borrowers will always welcome more financing options, LCD expects the private equity industry to continue to support both broadly syndicated and private credit markets. Ultimately, the growth of uncommitted capital at private equity firms will further drive demand for private credit longer term, with private equity firms having amassed significant dry powder to do deals, and these deals will eventually need financing.
In short, LCD expects the two markets to coexist longer term.
4. Less in distress
Thanks to a stellar pace of refinancing activity, record levels of amend-and-extend transactions and, of course, an uptick in defaulting companies that were flushed out of the performing market, several forward-looking stress measures paint an optimistic picture.
An important stressor is the burden of debt to be repaid, which has eased significantly. As of May 17, $44 billion of loans mature before the end of 2025, less than half of such maturities at the end of 2023.
Similarly, ratings agency activity has trended more favorably. The ratio of downgrades to upgrades on a rolling three-month basis has fallen to 1.82x in April, from a seven-month high of 2.42x in December.
Furthermore, the peak of distressed volume remains far below 2022 highs. The distress ratio of loans in the Morningstar LSTA US Leveraged Loan Index, calculated as the percent of performing loans priced below 80, was 3.95% in April, down markedly from its post-pandemic peak of 7.36% in December 2022.
In volume terms, less than $60 billion of loans are deemed as distressed, versus $108 billion at the December 2022 peak.
Given some large-ticket situations rolling off the trailing 12-month calculation in the coming months, and the improvement detailed in forward-looking metrics, PitchBook LCD expects default rates tracking bankruptcies and payment misses in the loan market to trend lower from here.
While restructurings in general will trend lower, LCD expects soft defaults in the form of liability management transactions to make up a significant share of the restructuring landscape, thanks to looser documentation, continuing a fairly recent trend in the loan market.
A case in point: LCD data show that in April, distressed liability transactions as a share of the total default landscape over the past 12 months was 54% by issuer count. During the 2020 default spike, the share of distressed exchanges (by count) was just 22%.
5. LBO green shoots
The number and volume of leveraged buyouts financed in the broadly syndicated loan market has improved from last year’s snail’s pace. Through May 16, sponsors raised $25 billion of syndicated loans to support this activity, more than double the $11 billion at this point last year. The momentum is encouraging, though buyout activity remains far below historical levels due to the elevated cost of debt and the logjam in sponsor exit activity.
On a bright note, investor appetite for risk is increasing, while the persistent shortage of new loan supply is compressing new-issue spreads on today’s LBOs to the lowest levels since 2007. The average spread for the roughly 20 LBOs launched this year is S+379, a full point tighter than during 2022. On a yield basis, the cost of debt is elevated, at 9.6%, but this is an improvement from a record high of 10.9% in 2023. For reference, LBO-related loans printed in 2021 were yielding 5% at issuance.
At the same time, LBO leverage ratios remain relatively mild versus pre-rate-hike peaks, while sponsors continue supporting transactions with record levels of equity.
As the BSL market continues to recover and the gap between loan supply and demand persists, what will the new crop of LBOs look like?
We expect leverage ratios to increase from 2023 levels, though not to recent peaks, while rates remain high. Despite recent spread compression, interest coverage ratios for new LBOs remain near post-GFC lows, at 2.4x. This suggests that elevated rates will continue to keep the lid on how much debt sponsors can raise to support buyouts while maintaining satisfactory cash flows to cover interest payments.
With that, market watchers are pushing forecasts for the return of golden years for LBOs out to 2025 and 2026.
6. High-yield bond issuance
The year 2023 was something of an anomaly for a historically unsecured high-yield bond market, as 60% of issuance included collateral backing. To put this into perspective, in the 10 years prior, secured issuance made up roughly a quarter of the overall supply picture.
In this regard, and in terms of overall volume, signs of normalization abound.
April featured $25.9 billion of total high-yield issuance, the most for that month in three years, as underlying rates subsided from recent heights.
All told, high-yield bond issuance totaled $111 billion for the first four months this year, up 88% from $59 billion at the same point last year.
Furthermore, the volume of senior unsecured issuance ($14.7 billion) topped secured volume ($11.2 billion) for the month, driving YTD totals through April to $57.8 billion for unsecured notes and $53.4 billion for secured deals.
Last year, secured volume for the first four months ($39.2 billion) was more than double the output of unsecured offerings ($18.6 billion), as high costs chased better-rated and regular issuers to the sidelines. Unsecured issuance last year ($69.4 billion) went on to trail the annual secured total ($105.4 billion) for the first time on record, LCD data show.
Looking ahead, if issuance for the rest of the year follows the post-crisis average, 2024 could see volume head toward $300 billion as issuers continue to refinance debt maturities and as M&A-related financings pick up.
7. CLOcking record vehicle creation
With the Fed keeping rates higher for longer, the loan market’s carry advantage continues. As such, loans are in heavy demand, and CLOs are issuing investment vehicles at a record pace.
Through the end of April, LCD tracked $66.2 billion of US CLO new issuance this year, far outstripping the $53.6 billion priced during the same period in 2021, the overall record year for CLO issuance.
This pace was maintained by the $17.4 billion of new-issue volume that printed in April, which ranks as the busiest April on record for new issuance in the CLO 2.0 era, as well as the second-highest monthly volume tally since November 2021, behind the $20.7 billion that cleared the market in February.
As record vehicle creation compounds the demand imbalance over supply, LCD is watching for a potential stretch for yield, and for more reset activity. On the heels of one of the largest refinancing waves, and with margins cut on a surge of repricings, CLO managers are focused on building back spreads lost during that time.
Indeed, year-to-date refinancing and reset activity has reached $58 billion through April 30, divided between $38.8 billion in resets that extended maturities and non-call/reinvestment terms of outstanding CLOs, plus $19.2 billion in refinancings that only apply new spreads to existing deal notes.
That four-month total of repriced deal volume already exceeds the annual total in three of the past four years. The exception is 2021, during which a record $233.7 billion in deals were reset or refinanced.
The months ahead
Going forward, the significant demand from CLO investors and mutual funds, along with the continued carry advantage of higher rates, is expected to sustain the outperformance of leveraged loans over high-yield bonds through the second half of this year. Nevertheless, high-yield bonds are enjoying their own revival as ETF demand has helped drive valuations to a two-year high. The asset class is expected to further benefit from investors locking in prospective yields that remain in the high single digits for newly issued bonds.
As this strong technical tailwind has loosened financial conditions, driving spreads lower and allowing issuers to address their maturity needs, concerns over whether the Fed would ease rates sufficiently enough to relieve financing pressures have dissipated.
However, as LCD data show, interest coverage ratios remain stretched for a subset of issuers, meaning pockets of weakness are likely to appear. In addition to greater dispersion in the lower end of the ratings brackets, liability management transactions will continue to feature heavily as a share of restructurings.
Featured image: Tetra Images/Getty Images
