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Q2 leveraged loan issuance no match for pandemic, Fed-fueled high-yield market

U.S. leveraged loan issuance cratered dramatically over the past three months — the first full quarter to register the upheaval caused by the coronavirus pandemic — though there were signs of improved activity as July approached.

Total institutional loan volume the type of debt bought by collateralized loan obligations and retail investors, as opposed to banks clocked in at a four-year low of $43.7 billion in the second quarter (as of June 25), according to LCD.

As unimpressive as that number is, especially compared to the soaring, Fed-fueled frenzy in the U.S. high-yield bond segment, it would have been worse were it not for a resurgence in June due to optimism over reopening of the economy. Indeed, new-issue loan volume in June alone accounts for 57% of total activity in the quarter, and it was the second-busiest month of 2020, behind a robust January.

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As with the broader economy, the onset of the pandemic abruptly halted loan issuance. Issuance by non-investment-grade U.S. borrowers in the second quarter plunged 51% compared to the first three months of the year, and was down 38% from the second quarter of 2019, according to LCD. More broadly, due to a gangbusters pre-pandemic start to the year, the $133 billion of U.S. institutional loan issuance in the first half is down only 9% year over year.

As noted, leveraged loan issuance badly lagged the sizzling bond markets in the second quarter. Federal Reserve programs designed to add liquidity to the markets ignited the investment-grade and high-yield bond asset classes, with issuance records toppled along the way. High-grade volume broke a monthly record in April, at $276 billion, and high-yield supply surged to its own record in June, hitting $52.7 billion (again, as of June 25).

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In comparison to loans, high-yield loans also benefited from supply/demand dynamics, as cash inflows into retail funds were massive in the second quarter, netting $40.5 billion through June 24, according to Lipper. In contrast, outflows from loan funds and exchange-traded funds continued, what with less-forceful backing from the Fed and what looks to be a non-rising rate environment for the medium term. However, loan outflows have eased noticeably from the hemorrhaging in March.

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Moreover, origination of CLOs, the loan market's primary source of demand, was snarled upon the onset of the crisis. However, CLO issuance has been consistently increasing month over month, helping to buoy overall demand in the asset class. In particular, managers have found ways to take bank warehouses that were already in place before COVID-19 and launch them into fully fledged deals in May and June, with increasing success.

Warehousing is a period where CLO managers purchase loans to be used as collateral in a full-fledged CLO vehicle.

To some extent, the appreciation of loan prices has helped boost CLO issuance, as manager portfolios appear less distressed to CLO debt investors now than they might have at the end of what was a dismal first quarter for the loan market.

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Additionally, CLO managers are reducing leverage, and in some cases retaining entire tranches of debt at the bottom of the CLO's capital stack, as to de-risk deals and obtain lower liability costs. But while those costs have started to compress slightly, even seasoned, trusted managers are paying much more to borrow from debt investors than they were just three months ago, a roadblock that likely will need to be overcome before issuance is to recover fully.

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Against that backdrop, the high-yield segment, clearly, became the market of choice for speculative-grade borrowers, with quarterly issuance in that asset class hitting $133 billion through June 25, easily the busiest quarter on record, and three times what was mustered in the loan market over the same period.

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The high-yield frenzy has launched a fundamental shift in the capital markets not seen in 10 years. Looking at all leveraged finance transactions tracked by LCD, only 48% of speculative-grade borrowers so far in 2020 raised all of their financing in the loan market, based on count, down from a 66% average in the prior five years. The first-lien, loan-only portion of leveraged finance is 44%, a 10-year low, trailing the bond-only share of 49%, a 10-year high.

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By itself, secured high-yield bond issuance ballooned to $52.3 billion in the second quarter, 75% higher than the prior quarterly peak, logged four years ago ($30 billion in second quarter 2016). It was the first time since the fourth quarter of 2009 that secured high-yield volume outpaced loan issuance in a quarter.

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As the loan market foundered, issuers looking to shore up cash positions amid the pandemic uncertainty tapped that fixed-rate demand: The share of the total high-yield volume for general corporate purposes was a whopping $44.8 billion in the second quarter, more than three times higher than the prior quarterly record, and 34% of the quarter's total issuance. To that point, bond-for-loan takeout activity has surged this year to its busiest level since 2013, according to LCD.

That scramble for liquidity has also breathed some life into the primary loan market, following the initial economic shock from COVID-19, as small incremental loans were secured in April. These initial forays, from issuers in sectors particularly battered by the crisis, came with juicy double-digit yields and lender-friendly bells and whistles, including enhanced call protection.

Gradual improvement of the loan secondary market during the spring opened the window for M&A-related loan commitments signed before the pandemic, propping up volume heading into quarter-end. Even with sizable deals, such as Thyssenkrupp Elevator and T-Mobile, which cracked open the M&A flow in April, leveraged buyout and M&A volume was at an eight-year low in the second quarter, at $23.3 billion.

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Of course, some M&A supply was siphoned into the bond market. The merger of Eldorado Resorts Inc. with Caesars Entertainment Corp. was financed largely with high yield; there was $6.2 billion of secured notes and just $1.8 billion from institutional term debt.

As arrangers rolled out these deals, the M&A pipeline thinned, and there has been little to take its place. The institutional forward calendar of M&A loans, topping $43 billion in late January, dwindled to roughly $12 billion by the end of June.

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The loan secondary has rebounded alongside a broad array of risk assets amid hopes of a coronavirus vaccine and the gradual reopening of economic activity, though volatility remains high, relatively speaking. After plunging 12.37% in March — the second-worst decline in the 23-year history of the S&P/LSTA Leveraged Loan Index — the year-to-date loss for the asset class had narrowed to 4.56% through June 29. This run-up was tempered late in June as COVID-19 cases spiked in several states, but the average bid price as of June 25 was 90.38, roughly 14 points higher than its 2020 low point of 76.23 on March 23.

As a result, the discounted spread to maturity of outstanding first-lien loans narrowed from post-coronavirus highs, as tracked by the S&P/LSTA Leveraged Loan Index. The average STM of issuers rated B+ or B narrowed to L+463 by June 25, from L+739 in March, while BB–/BB issuers had an average STM of L+324, down from L+458 in March. With that said, both cohorts are roughly 70 basis points wider than their 2019 average.

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As the new-issue loan market reopened, spreads on institutional loans averaged in the 425 bps area for both single-B and double-B issuers, underscoring that, to at least some degree, the market was in price-discovery mode during the month. This is understandable, given the current state of affairs, and what with credits from hard-hit sectors eyeing pricey liquidity loans. And the sample size is relatively small, with roughly a dozen deals in each rating category.

Examples of disparate pricings here include JetBlue Airways Corp. and Apergy, double-B rated issuers (JetBlue is split) that paid 525 and 500 bps over London interbank offered rate, respectively, while single-B names PQ Corp. and Ultimate Fighting Championship Ltd. paid 300 and 325 over.

For the record, B/B+ spreads averaged L+425 as of June 25 and BB/BB– spreads were at L+422.

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That said, all-in spreads, factoring in original-issue discount and the Libor floor benefit, were at their highest in at least eight years. At 627 bps at the end of May, the single-B measure is 130 bps higher than at the end of the first quarter and 284 bps higher than on Jan. 31, a reading of 342 bps that was the lowest since the global financial crisis. Double-B spreads hit a post-crisis high of 609 bps in May, a whopping 396 bps higher than in January.

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Up-front fee contribution to all-in pricing was significant, averaging around 118 bps as of May (amortized over three years), a record high. That average incorporates M&A deals priced at steep discounts as arrangers moved them off the books, especially early on in the reopening of the market. But by and large new issues were offering deeper original issue discounts.

This article was written by Jon Hemingway, who covers the leveraged loan market for LCD.