Finance

Navigating the Paradigm Shift in US Leveraged Loan Market

In the unforgiving realm of US debt markets, the axiom has always been that those first in line reap the ripest rewards when companies face financial demise. However, a recent trend has emerged, as high-risk US corporations increasingly opt to borrow exclusively via the loan market, ensuring that their sponsors—those providing the funds—are often awarded the coveted position of 'first lien'. This term signifies that they have preferential claim over assets in cases of insolvency. This shift, however, brings to light a concern with broader implications for the market, especially with the decline in the issuance of subsequent, subordinate debt classes.

Source: Fitch Ratings

A report from Barclays highlighted a stark decline in second-lien debt, which now constitutes a mere 2.4% of the Morningstar LSTA Leveraged Loan Index as of January. The contrast is stark when one considers that over 5% of the index was made up of such debt merely a decade ago.

The Declining Safety Net of Junior Debt

The financial landscape is witnessing a significant escalation in companies holding a thin buffer of junior debt, particularly subordinated borrowings. Only about a quarter of their debt fits this category. This is up drastically from roughly 35% a decade ago—a significant jump to about 60% in 2022, according to a report by S&P Global Ratings.

Issuers find it financially prudent to bypass junior debt as it conventionally commands higher interest rates, applied to compensate asset managers for taking on additional risk. This economization, however, sets the stage for a tougher scenario when these entities flounder. Fewer categories of debt mean fewer classes of investors to bear the financial brunt of a default, explains Lyuba Petrova, managing director of US leveraged finance at Fitch Ratings.

This phenomenon is no longer theoretical, as current data on distressed debt elucidates. In situations where defaulting companies lacked second-lien or other junior debt, first-lien lenders reclaimed approximately 45.7 cents to the dollar last year. In contrast, the figure stands slightly better at 54.2 cents for companies with debt spanning a broader spectrum of markets, according to Fitch Ratings.

Heightened Risks Amidst Economic Softening

Unfavorable recovery prospects add yet another layer of risk for creditors facing the double-edged sword of persistently high Federal Reserve rates and looming default increments as economic conditions wane. The anticipated outcome of the Federal Reserve's meeting is a further complication that, later on Wednesday, will be revealed to an anxious market.

"All else being constant, the value available is finite, and first-lien creditors will, by default, be at the forefront to claim that value in mixed capital structures," says Fitch's Petrova.

The grim recoveries are feared to fuel an already burgeoning trend of aggressive maneuvers by fund managers who covertly negotiate to extract some value from faltering investments. These off-the-record deal-makings often leave the excluded lenders facing a stark disadvantage.

The Evolution of Loan Market Dynamics

The reduction in second-lien offerings is additionally attributed to a transition toward private credit and the prevalence of unitranche deals. Unitranche financing is an approach that essentially levels the playing field among creditors. Barclays strategists, in a February memo, speculated on the persistence of subdued second-lien issuance amid ongoing private capital influxes.

There's also the economic component of subordinated debt carrying, which often results in companies incurring about two percentage points more on annual interest rates than traditional first-lien debt. This economic burden drove enterprises to the fervent debt market in January, where they took advantage of favorable terms to supplant their higher-ranked liabilities with less expensive alternatives. Such capital structure simplification further narrowed the already depleted landscape of second-lien debt. This trend observed a continuation through February.

Despite the shift, some appetite remains for subordinated loans among both issuers and purchasers. March 8 witnessed an arrangement where arrangers sold a notable second-lien loan valued at $1.9 billion—one of the heftiest for a leveraged acquisition—part of the finance package for Stone Point Capital's and Clayton Dubilier & Rice's near $15 billion acquisition of the insurance arm of Truist Financial Corp. The loan, notably, was priced at 475 basis points above the Secured Overnight Financing Rate, which was tighter than the initially anticipated 500 points over the benchmark.

Such occurrences were sparse, with investors encountering only the second instance of junior debt since July the previous year. Prior to this, in February, Applied Systems Inc. had priced out $565 million in debt at 525 basis points over SOFR.

"It's a positive indication to see junior capital not strictly sequestered to the private credit sector," expressed Michael Best, a portfolio manager at Barings. He continued, "The search for additional yield opportunities is in full swing, with investors considering second lien or junior tranches, which applies to CLO managers and assorted fund types. Typically, a second-lien position in a robust business is more attractive than a first-lien in one that is struggling."

The resurgence of deals giving investors a larger protective buffer is uncertain but would be timely. Fitch Ratings hints at US loan and bond default rates potentially climbing up to 4.5% throughout the year, compared to around 3% nearing the conclusion of last year.

The Threat of Liability Management Transactions

For investors ensnared in top-heavy capital structures, a pressing peril awaits—liability management transactions. These sophisticated out-of-court restructurings often obscure recovery prospects for nonparticipants, an issue brought to light by S&P.

Such transactions are becoming increasingly routine, further complicating the already enigmatic equations governing recovery rates. Investors are tasked with the crucial responsibility of deciphering the true nature of the risks involved with their investments, a duty that Chris Long, the CEO of Kansas City-based investment firm Palmer Square Capital Management, insists is imperative in today's market.

In a landscape characterized by unyielding Federal Reserve rates, evolving debt market dynamics, and economic softening, the steadiness of investment returns is increasingly unsettled. While certain large-scale second-lien loans hint at a possible resurgence, the market's appetite for junior capital outside the private terrain remains tepid. The coming months will be a true test for the US leveraged loan market, as investors watch anxiously to see whether the trend will reverse or if they will need to adapt to a new standard where senior debt is the norm and junior debt a rarity.

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