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The leverage finance market in the US is far too hot. The issuance of leveraged loans, generally referred to as junk rated, jumped 72% last year to US$1.14trn, according to Thomson Reuters LPC. Not much seems to be slow it down. Although primary high-yield issuance so far this year is US$108.8bn, slightly down on the US$125.6bn issued in the same period last year, junk issuance is up from US$120bn to US$135.9bn.
What has driven the frenzy is the hunt for yield. Let’s not forget that US Treasuries are still only yielding 2.46%. The enthusiasm for any kind of a return means that the yield-to-worst on high-yield bonds is just 5.04%, not far off the historic low of 4.95% reached this time last year, according to the Barclays High-Yield Index.
As Bradley Rogoff, head of US credit strategy at Barclays, wrote in a damning recent note: “The overall structure of the loan market has unquestionably deteriorated.” It is no surprise that second-lien supply is up about 20% year on year.
So concerned are US regulators about increasingly un-vanilla structures with PIK toggles and Triple C ratings, that those with longer-term memories are having flashbacks to the 1980s and the excesses of Drexel Burnham Lambert. Indeed, the balance of power has swung so heavily towards the issuer that covenants are falling by the wayside and shorter call protection periods are not only making an appearance, they are becoming the norm.
A stern talking-to
As Rogoff explained: “Nearly two-thirds of issuance since the beginning of 2013 has been covenant-lite, and about half of the outstanding loan market is now cov-lite as a result.”
At the beginning of May, Federal Reserve chair Janet Yellen put her foot down. She spoke of her concerns about risky investment behaviour in the wake of the current extended period of low rates. “Some reach-for-yield behaviour may be evident,” she said – in Fed-speak the equivalent of a stern talking-to.
“It is significant that Yellen is talking about it. It sends a signal to the banks to take it seriously,” said Paul Forrester, a partner in Mayer Brown’s structured finance practice.
What has put the cat among the pigeons is the annual Shared National Credit (SNC) review by regulators. Established in 1977 by the board of governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency, it was designed to police risk in the largest and most complex credits shared by multiple financial institutions.
In a show of unity between the Fed, OCC and FDIC, all three are increasingly putting pressure on banks to stick to underwriting criteria amid concerns that the market is getting frothy, and they are targeting leveraged lending in general and leveraged loans in particular.
Yellen’s message was reiterated a couple of weeks later at the 2014 Credit Markets Symposium in Charlotte, North Carolina. Todd Vermilyea, senior associate director for banking supervision and regulation at the Fed, said that the SNC this year would assess banking conduct and adherence to “safe and sound lending standards”, and added: “Terms and structures of new deals have continued to deteriorate in 2014.”
A week later, New York Federal Reserve president William Dudley called the leverage loan market frothy and said: “I am nervous that people are taking too much comfort in this low-volatile period and as a consequence of that, taking bigger risks.”
It is clear that this time the regulators are not joking. Unity is certainly needed. There has been a perception that not all banks in the US have been treated in the same manner. It is generally believed that US deposit-takers such as Bank of America and Wells Fargo have had a tougher time as they are regulated by the very vocal OCC, while bank holdings such as Goldman Sachs, Credit Suisse and Morgan Stanley, are regulated by the Fed, which has had a more hands-off approach.
“One thing is clear: there is not a level playing field,” said one New York-based senior debt capital markets banker.
Perhaps more seriously, there are questions about the leveraged lending guidelines that were released in March last year. Although the premise is solid – to “cover transactions characterised by a borrower with a degree of financial leverage that significantly exceeds industry norms” – many are unhappy with the details. The notes that leverage levels should not exceed six times debt-to-Ebitda after asset sales have come in for particular criticism.
Many market participants agree – both on the buyside and the sellside – that the six times leverage ceiling is too broad-brushed. “Six times leverage is simply too blunt a tool,” said Mayer Brown’s Forrester.
It is a difficult call as it is a generally useful indicator. About 40% of this year’s leveraged buyouts had debt of more than six times earnings before Ebitda, up from less than 30% last year, according to Standard & Poor’s Capital IQ Leveraged Commentary & Data. But it is the lack of nuance that has annoyed the industry.
“It’s nonsense. If you were to leverage a newspaper four times, it would be a complete disaster. But if you’ve got a software company that has contracts locking in revenues for three years, it can handle leverage of say 7.5 times, as it will be able to reduce leverage relatively easily over the next few years,” said one banker.
Sniping about details aside, it is worth stepping back and asking the broader question of whether the regulators’ aims are working. Perhaps inevitably, the answer is both yes and no.
It has worked to the extent that banks are thinking much more carefully about leveraged lending. The tipping point was two deals in March, one that reminded overly enthusiastic investors that Caa1/CCC companies come with risk, and another that was a wake-up call ahead of the SNC.
The first was the US$350m PIK bond issue from coal producer Walter Energy in the second half of March. The six-year 11% was cash-priced at Treasuries plus 893bp, but in secondary trading dropped almost at once from par to 94 in cash terms. The yield-to-worst jumped to around 13.6% and although there was the inevitable belly-aching about mispricing, the relentless bearishness on the sector and the slew of negative analyst reports on the company should have been some kind of a warning to investors.
The second deal in the same week was the US$1bn eight-year non-call three leveraged buyout bond for Starr Investment Holdings’ buyout of healthcare company Multiplan. Although rated Caa1/CCC+, books hit US$6bn and the deal was priced comfortably inside the 6.75% guidance with a 6.625% coupon. What was significant here was that only two banks – Barclays and JP Morgan – underwrote the deal. Others steered clear, pointing to the 7.3 times leverage and a desire not to attract the regulators.
Element of sobriety
Since then, an element of sobriety has hit the market and mid-April saw this dramatically when an unprecedented 95 straight weeks of inflows stopped. From the week ending April 16, bank loan mutual funds recorded three consecutive weeks of outflows. In that three-week period, retail investors withdrew more than US$900m in cash.
A number of deals have been put on ice. Software development firm Rocket Software withdrew a proposed US$725m covenant-lite loan to refinance existing debt and fund a dividend to founders and financial sponsor Court Square Capital. This was after Moody’s revised its outlook on the company to negative.
The ratings change was “driven by the large increase in debt as a result of the proposed equity distribution and limited flexibility within the B2 rating category, particularly given Rocket’s acquisition appetite”, the agency said.
Dutch LLC, which does business as women’s clothing company Joie, scrapped its proposed US$200m Term Loan B to refinance the company’s existing term loan and mezzanine debt. Bank of America Merrill Lynch launched the term loan in early April at price talk of Libor plus 500bp–525bp, with a 1% Libor floor and an offer price of 99–99.5. The loan would have included a total-leverage test and would have sat behind a US$20m, five-year super-priority revolver.
Capella Healthcare pulled a US$585m first and second-lien loan package, which was to refinance a US$500m 9.25% 2017 bond issue, as well as fund the purchase of a MCH Capital lease and repay a MCH promissory note. The first-lien tranche had been talked at Libor plus 375bp–400bp, with a 1% Libor floor, offered at 99–99.5, while guidance from Bank of America Merrill Lynch, Citigroup, and Credit Suisse on the second-lien was Libor plus 700bp, with a 1% Libor floor, offered at 99.
While banks might now be more cautious about lending to parts of the leveraged loan market, bankers remain sceptical that it will solve the problem. As long as interest rates remain so low and with no rise likely until the second half of next year, the search for yield will simply continue to the fuel the problem.
“The SNC review will not work at all,” said one banker bluntly. “There are alternative sources of capital. Companies will just move from asset class to asset class.”