A market that was recently described by rating agency Standard & Poor’s as “a dangerous mix of loosening loan terms, lower credit ratings and higher debt levels” is probably not one that regulators should be eager to relax their rules for.
This is how the agency characterised the US leveraged loan market on October 16. Just three days later, however, the US Government Accountability Office announced that it has placed the 2013 guidelines on leveraged lending, which were designed to limit risky lending in this market, under review.
This means that they could be overturned by Congress and abandoned.
How concerned should the market be about this?
Firstly, the chances of a complete abandonment of any guidelines in the short term is reasonably low. The announcement by the GAO is the result of a request for clarification on the legal status of the guidelines that was made by US Senator Pat Toomey in March.
The GAO has determined that the guidelines, which were put in place by the Federal Reserve, the FDIC and the OCC, are a formal federal rule, not voluntary guidance.
Congress was not notified when the guidelines were put in place; if they now function as law, then they can consequently be voted down.
“Precedent suggests that Congress can exercise its authority to disapprove such a guidance,” Toomey stated once the GAO decision was made public.
The guidelines have certainly curtailed leveraged finance activity at many US banks and have been a boon for lenders outside the remit of the regulators. Nomura and Jefferies have picked up business since the guidelines came into force, and private equity giant KKR has come from nowhere to now rank in the top 20 of US leveraged loan underwriters.
The US leveraged loan market had already racked up issuance of $874.7 billion by August this year, topping the full-year $492.9 billion volume for 2016 by 77%; some $55 billion of paper was sold in September alone. In the third quarter of 2017, 43% of issuers were rated just single-B.
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The proportion of covenant-lite deals is now 73% – up from 5.1% in 2010. The desire for floating-rate exposure has seen issuance of US leveraged loans surge ahead of that for US high-yield bonds, of which roughly $250 billion have been issued already this year. The extraordinarily accommodative conditions in the loan market have also spurred a wave of refinancing and repricing. According to Morgan Stanley and S&P research, the first quarter of 2017 saw $223.8 billion of loan repricings, which produced an average spread saving of 92 basis points.
The second quarter of the year saw less activity ($109 billion) and a smaller saving (85bp), but interestingly the number of months between the original deal and the repricing fell to 12 from 17.8 in the third quarter of 2016.
This looks like a market that needs to be reined in, not freed up. But in leveraged finance, the thing that matters is defaults. And at the moment it seems that they don’t.
On October 16, Bank of America Merrill Lynch forecast a full percentage point decline in the US issuer default rate from 3.3% in September to 2.3% by September next year.
“Some measures of issuer debt leverage have risen to levels not normally seen outside of high default environments,” the bank concedes. But it argues that the distorting effect of the issues in the oil sector mean that the true leverage picture is more nuanced: “Measures of corporate debt leverage, while elevated in absolute terms, are still disproportionally affected by energy names to this day.”
Not everyone on the buy side is as relaxed, however.
The IACPM third-quarter credit outlook survey, which was published on October 19, shows that credit portfolio managers believe that defaults will increase over the next 12 months.
In North America, 53% of respondents believe that defaults will increase over the longer term. The collapse of Toys R Us, which filed for bankruptcy in mid-September weighed down by its $5 billion debt load, is a timely reminder of where risky lending and overleverage took this market prior to the financial crisis.
In Europe, despite concerns over Brexit, Catalonia and the future of quantative easing, two-thirds of respondents to the IACPM survey do not expect any uptick in corporate defaults.
This reflects the eerily benign conditions that prevail in sub-investment grade in Europe just as the ECB, which published its own guidance on leveraged lending in May this year, is poised to begin tapering QE.
A record $143 billion of leveraged loans and high-yield bonds were issued in Europe in the first half of 2017 – 7.6% higher than for the whole of 2016.
In early October, the BAML European high-yield bond index was actually yielding less than 10-year US treasuries: 2.29% against the latter’s 2.32%. This should mean that US treasuries are a riskier investment than European high-yield bonds, which is patently nonsense.
Just six corporate issuers in Europe defaulted in the first half of 2017, which translates into a default rate of 0.64% versus 1.9% for the same period in 2016, according to Fitch Ratings.
The default rate for triple-C credits is 5.7%, single-B is 0.57% and double-B 0.19%.
“Triple-C rated bonds hardly compensate investors for the default risk that they bring, and we would question holding anything but highly selective exposure at these yield levels,” says John McGrath, partner and head of distribution at Twenty Four Asset Management in London. “The gap in default rate to single-B is always big, but currently the spread is not.”
The euro high-yield index returned 2.37% in the second quarter of the year.
On October 18, Spanish car park operator Empark Aparcamientos y Servicios issued a €425 million double-B rated deal through JPMorgan that was priced well inside guidance, and single-B rated French oil and gas industry supplier Vallourec priced a €300 million deal 25bp inside guidance through Morgan Stanley.
