Jan. 22 2019 — The pace of leveraged loan issuance plunged in December, as if all the tensions that have been simmering for the past year came to a boil. Concerns such as the build-up of corporate debt and rising borrowing costs cooled investor sentiments and played a role in why only $76 billion of institutional loans were allocated in the primary market during the last quarter of 2018. This is 23% lower than the same quarter last year and the lowest since the first quarter of 2016 according to S&P Global's Leveraged Commentary & Data (LCD). The recent shift in market tone has certainly clouded the 2019 outlook, but overall we expect new issue volume to likely recover most lost ground albeit gradually as issuers who were holding out for the right window begin to return to the primary market. As corporate fundamentals remain encouraging this far into the cycle, we expect the bulk of new 2019 loan issuance will continue to come from M&A and LBO transactions.
In the meantime, our recovery estimates for first-lien debt weakened throughout the majority of 2018, despite a marginal improvement in the last quarter. The consensus is the usual suspects have been at play, ranging from smaller junior cushion undermining first-lien position to the covenant-lite structure reducing lender protections. Here we look at the most significant developments (or resurgence of risk) of 2018.
Leveraged Loan Volumes And Trends
After a prolonged period of record issuance, the U.S. leveraged loan market lost its charm at the tail end of 2018. New issuance volume in the fourth quarter, including both pro rata and institutional loans, slid to $119 billion, approximately half of Q2's intra-year high of $209 billion. Much of the scale-back reflects the same concerns that have been gripping the high-yield and equity markets: collateral effects of interest-rate normalization, broadening of trade-related dispute, and slowdown in economic growth, to name a few.
Yet even with the sharp retreat in December, 2018 still stands as the second-strongest year in the post-crisis era. Total leveraged loan issuance in 2018 was $619 billion, only behind last year's record $650 billion. This is thanks largely to still attractive risk-adjusted returns on leveraged loans when compared with other asset classes. Another bright note--earnings growth has caught up with debt growth in 2018. Strong EBITDA growth, which swelled to a seven-year high of 13% in Q3 according to the LCD, lays the groundwork for M&A and LBO activities. Indeed, investors' risk appetite was put to the test in September when supersized LBOs came to market. The result? The demand was so strong that investors ceded more ground on the covenant battlefield. For example, Refinitiv landed what was considered to be extremely aggressive deal terms. This includes a broad definition of EBITDA that allows for adjustments for run-rate cost savings within 24 months, among other things. Such generous add backs may provide the company with additional borrowing capacity under incurrence covenants than would otherwise be permissible in comparable transactions.
When tallying the numbers, about 33% and 27% of institutional loans by volume backed M&A and LBO transactions last year, respectively. This surpassed opportunistic activities like refinancing and dividend recapitalizations, which collectively accounted for 33% of total institutional issuance during 2018. After last year's intense refinancing activity, rising borrowing costs (a combination of surges in interest rates and new-issue spreads) have squeezed out most remaining incentives for refinancing.