Recent leveraged buyout activity signals that strong investor demand remains, however.
Alarm bells may be ringing in some corners of the financial markets but it appears that normal service continues without a hitch.
U.S. businesses are borrowing at record rates, even while corporate profits and the economy remain strong. While companies issuing debt with investment-grade ratings make up the bulk of corporate debt outstanding, below investment-grade companies, or junk-rated firms, are issuing their share of loans and bonds on much more favorable terms than they have in the recent past.
Back in late August, Mark Zandi chief economic for Moody’s analytics, wrote1 that the “most serious developing threat to the current cycle” is lending to highly-leveraged non-financial businesses – loans to companies that already have considerable debt with below investment-grade ratings.
Leveraged loan volumes are setting records, with loans outstanding increasing at a double-digit pace in the past five years to $1.4 trillion. And when issuance in the junk corporate bond market is included, highly-indebted nonfinancial companies owe about $2.7 trillion, according to Zandi.
“Their debts have been accumulating quickly as creditors have significantly eased underwriting standards. As interest rates rise, so too will financial pressure on these borrowers,” Zandi wrote. Despite this, global investors “appear sanguine,” as credit spreads (or the risk premium over safe government debt) in the loan and junk bond market are narrow by any historical standard, he said.
Perhaps a notable example of that sanguineness among investors and one that’s caught the attention of market participants and the financial press is the $17.0 billion leveraged buyout of Thomson Reuters’ financial-data business. Institutional investors led by Blackstone Group will now own 55% in the new firm known as Refinitiv. Thomson Reuters is retaining the other 45%.
The well-received transaction from investors was completed on September 18. The deal included a $13.5 billion debt offering ─ $9.25 billion of loans and $4.25 billion secured and unsecured bonds. It was one of the largest leveraged buyouts since the financial crisis and also seen as a barometer for investors’ appetite for very low-rated debt with favorable terms to the issuer.
Indeed, a closer look at some of the deal’s terms and conditions reflect trends that have taken shape in the broader credit markets in recent years. When Moody’s assigned a corporate family rating2 to Refinitiv earlier in September, it figured that Refinitiv’s debt would be more than seven times the company’s earnings before interest, taxes, depreciation and amortization (EBITDA). That compares to median leverage of 6.6 times for B3-rated companies (considered highly speculative and equivalent to a single-B-minus rating from Standard & Poor’s and Fitch Ratings).
Banking regulators including the Federal Reserve issued leveraged lending guidelines in 2013 aimed at addressing the market’s growth since 2001 and the 2008 global financial crisis. Those guidelines were clarified in February 2015 when regulators indicated a leveraged loan with total debt to EBITDA in excess of 6 to 1 could raise a red flag. Earlier this year, however, banking regulators signaled that the guidelines are nonbinding.
Other Safeguards Eroding
Underwriting standards on the lending front are also easing. In the most recent Federal Reserve survey3 of senior loan officers at commercial banks, 17.4% of respondents said they had “eased somewhat” their credit standards for commercial & industrial loans (C&I) or credit lines – other than those used to finance mergers and acquisitions.
The survey released in July also found that 21.7% of loan officers had somewhat eased their loan covenants in the current quarter compared to the previous quarter.
These days, upwards of 80% of outstanding leveraged loans are so-called “covenant lite” loans, meaning that lenders have fewer protections in terms of collateral, debt cushions and what assets are available for recoveries should an issuer default or declare bankruptcy.
The Bank for International Settlements took up the topic of leveraged loans in its September Quarterly Review4 noting that, as business cycles mature, investors may start to incur losses. The default rate for these loans in the U.S. has already ticked upward to 2.5% as of June 2018, compared to around 2.0% in mid-2017.
And as these loans are floating-rate, meaning they typically reset on a monthly or quarterly basis as interest rates change, companies could experience higher debt servicing costs. Higher debt coverage ratios, or the ratio of net operating income to debt service costs, could trigger defaults, the BIS said in its Quarterly Review.
“The combination of aggressive financial policies, deteriorating debt cushions, and a greater number of less creditworthy firms assessing the institutional loan market is creating credit risks that foreshadow an extended and meaningful default cycle once the current economic expansion ends,” Christina Padgett, a Moody’s senior vice president, said in a mid-August press release5 on the convergence of the loan and high-yield bond markets.
1 Zandi, Mark. (2018, August 23) Significant Differences, Eerie Similarities. Moody’s Analytics: Weekly Market Outlook, p. 2-4. Moodys.com. Retrieved from: https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1139134
2 Moody’s Investors Service. (2018, September 5) Rating Action: Moody’s assigns first-time B3 CFR to Thomson Reuters’ Financial & Risk unit (Financial & Risk US Holdings, Inc.); rates new sr sec credit facilities and sr sec notes B2, sr unsec notes Caa2; outlook stable [Press release]. Retrieved from: https://www.moodys.com/research/Moodys-assigns-first-time-B3-CFR-to-Thomson-Reuters-Financial–PR_388354
3 The Federal Reserve. (2018, August 6) Table 1: Senior Loan Officer Opinion Survey on Bank Lending Practices at Selected Large Banks in the United States (Status of Policy as of July 2018). Retrieved from: https://www.federalreserve.gov/data/documents/sloos-201807-table1.pdf
4 Goel, Tirupam. (2018, September 23) The rise of leveraged loans: a risky resurgence?. BIS Quarterly Review, p. 10-11. Retrieved from: https://www.bis.org/publ/qtrpdf/r_qt1809u.htm
5 Moody’s Investors Service. (2018, August 16) Announcement: Moody’s: Convergence of loan and high-yield bond markets sets stage for lower recoveries in next downturn [Press release]. Retrieved from: https://www.moodys.com/research/Moodys-Convergence-of-loan-and-high-yield-bond-markets-sets–PR_387880
Source for Leveraged Lending Guidance:
Willkie Farr & Gallagher LLP. (2016, February 18) Client Memorandum: Leveraged Lending Guidelines – 2013 to 2015 Impact. Retrieved from: https://www.willkie.com/~/media/Files/Publications/2016/02/Leveraged_Lending_Guidelines_2013_to_2015_Impact.pdf
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