In the last few weeks there have been clear signals from the U.S. credit market of an increasing level of stress at the weaker end of the credit spectrum. Perhaps the most telling data point that we’ve seen is the…
In the last few weeks there have been clear signals from the U.S. credit market of an increasing level of stress at the weaker end of the credit spectrum. Perhaps the most telling data point that we’ve seen is the sharp drop in total high-yield borrowing (junk bonds and leveraged loans combined), which according to Moody’s plunged by 37% in the third quarter from a year ago. For the 12-month period, total high-yield issuance is down 29% from the 12-month all-time peak recorded in 2013.
And in October, according to S&P Capital IQ’s LCD, the trend became even more pronounced, with only seven junk-bond deals clearing through last week, for a meager total of $3.7 billion.
Does this unease in the credit market portend trouble for the deal market? Certainly, risk aversion among credit investors and a souring of appetite for junk bonds can quickly translate into a limitation on the availability of financing for leveraged M&A activity. As the Wall Street Journal reported recently, a few large leveraged transactions, such as Olin Corp’s acquisition of a division from Dow Chemical and Altice’s purchase of Cablevisions Systems, have recently encountered tepid appetite from credit market investors, with the result that both deals only cleared after being scaled back and repriced at higher than anticipated levels.
But the Olin and Altice transactions both closed since the bankers were able to increase the size of the second lien loan financings to make up for the shortfall in the size of the junk bond financings. So for borrowers willing and able to provide collateral or live with loan covenants, there is still liquidity available to fund leveraged transactions.
The primary damage so far has been confined to weaker credits. There has clearly been a flight to quality in the corporate credit market, with credit investors shunning or reducing their exposure to distressed high yield debt and loading up on higher rated paper. As a result, as S&P notes in its most recent LCD report – it’s been a rotten year for distressed and defaulted loan paper, with the annual returns of performing leveraged loans (shown in red bars in the graph below) up a modest 2.4% year-to-date compared to the returns on defaulted loans (shown in the blue bars) which have collapsed by – 33.6%. As a result, this year is shaping up to be the worst performance at the risky end of the leveraged loan market since the financial crisis in 2008, with the widest spread between the losses on defaulted loans and the gains on performing loans.
Given this rotation in the credit markets, it seems reasonable to expect an increase in the general default rate (which has been at historically low levels in the last few years thanks to the Fed’s policy of quantitative easing), as weaker companies face more difficulty when it comes time to refinance. But in and of itself, the increased level of stress faced by weaker credits does not necessarily pose an immediate threat to the general deal marketplace or the prospects for the overall U.S. economy. In fact, more caution among credit market investors may actually be a good thing at this point in the credit cycle inasmuch as it helps us avoid some of the excesses and ridiculously over-leveraged deals that came to market in 2006 and 2007 during the run up to the last market crisis, which might make the next downturn less severe, whenever it arrives. In the meantime, interest rates remain low and credit is still available for stronger and medium grade credits, so the deal economy continues to motor along.