What are the key themes to shape the Leveraged Loan and High Yield Bond markets in 2021 and beyond?
1: Credit quality
This is expected to remain a question mark in the leveraged loan market. The deterioration of the ratings mix in the S&P/LSTA Leveraged Loan Index began playing out long before the COVID-19 pandemic inflicted damage to corporate balance sheets in early 2020. The subsequent rush of downgrades, and more recent, record-breaking pace of lower-rated issuance, has exacerbated that decline.
2: The reach for yield
The long-standing challenge of yield pick-up during the record bull market run, amid central-bank liquidity policies, has returned. Credit investors are once again faced with near-record low yields, which could encourage more risk taking in the search for incremental spread.
Indeed, in mid-April, the yield to maturity of the S&P/LSTA Leveraged Loan Index was hovering around 4.3% - just 8 basis points shy of the 2004, 4.25% record low. The high-yield market hit a record low on Feb. 16 of just 3.86%. Per the S&P U.S. High Yield Corporate Bond Index, this is the first time the yield-to-worst has ever dipped below 4%.
3: Environmental, Social, and Governance (ESG) investing
Momentum around ESG investing in speculative-grade credit is expected to build into 2022. Sustainability-linked borrowing in the leveraged finance markets remains at a nascent stage, although widespread adoption is expected, with Europe leading the charge. Indeed, some private equity sponsors are looking at committing to including ESG-linked constructs on all financings for their portfolio firms.
So far, ESG-related structures utilized by leveraged loan borrowers in Europe have included margin ratchets linked to KPIs, or linked to third-party ESG scores, with expectations that this could become the norm.
In addition, CLOs – the largest buyers of leveraged loans – are increasingly incorporating ESG-related sector considerations into their frameworks.
In conclusion, Leveraged Finance issuance has soared so far in 2021, and that looks to continue, if borrowing costs remain low and the economic recovery holds. The big question is: what will happen to credit quality if that's the case, as investors search for yield skews the market towards the riskiest borrowers?