Key Takeaways

Lenders and borrowers in US leveraged finance markets have had to recalibrate pricing and issuance volume expectations in 2022 in the face of rising inflation and interest rates.

The abundant liquidity that stoked red hot leveraged loan and high yield bond markets in 2021 dried up through the first half of 2022, as macro-economic uncertainty, events in Ukraine, soaring energy prices and-COVID-19 supply chain bottlenecks drove up prices for goods and services and left central banks worldwide with limited alternatives to maintain low interest rates.

US Labor Department figures showed inflation for consumer goods rising by 8.5 percent in March, representing the largest year-on-year increase since 1981. In response, that same month, the US Federal Reserve raised interest rates for the first time in three years to fight inflation, upping rates by 0.25 percentage points.

At the beginning of May, the Fed proceeded with a 0.5 percentage point increase and in June, as inflation reached a 40-year high, interest rates were increased by another 0.75 percentage points—the largest hike since 1994. By July, with inflation remaining stubbornly high, the Fed raised rates once again by 0.75 percentage points.

Further rate increases are in the pipeline, with liquidity also expected to tighten as the US Central Bank scales back its US$9 trillion balance sheet.

High yield bonds take strain

Since January, the US Federal Reserve has raised interest rates four times, taking its benchmark funds rate to a range of 2.25 – 2.5 percent

The impact of climbing interest rates and inflation on US leveraged finance markets has been most keenly felt in the high yield bond space.

As fixed rate instruments, high yield bonds are vulnerable to rate hikes, which eat into bond investor returns. This has resulted in material amounts of capital being pulled out of high yield bonds—data from Lipper shows that, in the first four months of the year, US$27 billion flowed out of the asset class.

This has resulted in a challenging market for issuers. According to Debtwire Par, high yield bond issuance was down 76 percent in H1 2022, year-on-year, to US$63.6 billion.

High yield bond issuers that have come to market have paid higher rates to convince investors to back their offers. Used car retailer Carvana, for example, paid a 10.25 percent coupon to land a US$3.27 billion unsecured eight-year bond in April to fund the acquisition of ADESA’s physical auction business. By comparison, eight months earlier, in August 2021, Carvana had tapped the market for an unsecured eight-year bond priced at 4.875 percent.

Dallas-based glass and glazing manufacturer Oldcastle, meanwhile, paid a 9.5 percent coupon and offered a discounted issue price (92.12 percent) to investors on a US$585 million secured bond used to fund a portion of its leveraged buyout by KPS Capital Partners.

Carvana and Oldcastle both received ratings in the lowest bracket (CCC+ or lower) and, in a market characterized by thin volumes, accounted for more than half of monthly issuance in April. As a result of these two bond issues, average yields on senior secured and unsecured bonds spiked from 5.71 percent in Q1 2022 to 8.07 percent in Q2, according to Debtwire Par.

Even higher-rated credits have been affected by the volatile inflationary environment. BB-rated engineering and construction company Global Infrastructure Solutions, for example, priced a ten-year US$300 million senior unsecured note at 7.5 percent and par, but has seen pricing in the secondary market drop to 88.7 percent of par, for an implied yield of 9.25 percent.

Leveraged loans face challenge

The leveraged loan market has been shielded from macro-economic headwinds to a degree, as the floating rate structures on loans rise in line with increasing interest rates, but it has not been immune from the impact of these market fluctuations.

Up to May 2022, leveraged loan funds had enjoyed a run of 18 months of consecutive growth in assets under management, according to S&P and Lipper. From the beginning of May to the end of the week ending June 22, however, more than US$6 billion has exited the market as investors have become more risk-averse.

Activity in the collateralized loan obligation (CLO) space—the largest pool of investors in leveraged loans—has also eased, particularly in refinancings. New CLO issuance is down 12 percent year-on-year for the year to the end of May 2022, while CLO refinancing issuance has dropped by 94 percent. This may pivot again as and when things improve, however, as CLOs have proven to be resilient throughout the worst of the pandemic to date.

With demand for loans tightening, loan prices have moved higher. According to Debtwire Par, average margins on first-lien institutional term loans climbed to 4.31 percent in Q2 2022, well above the Q1 2021 average of 3.96 percent and the 3.74 percent average recorded in Q2 2021.

Despite some bleak headlines, the market is still open for business—Refresco Gerber raised a US$4.1 billion-equivalent multi-currency loan package to back its buyout by KKR, while Therm-O-Disc secured a US$360 million term loan B for its buyout by One Rock Capital Partners. While the loan space will no doubt recover its momentum in the months to come, interest rates and inflation are resetting market expectations.

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