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US Leveraged Loan Funds See $731M Retail Cash Inflow

U.S. loan funds recorded an inflow of $731 million for the week ended May 16, according to Lipper weekly reporters only. This marks the largest inflow since $863 million for the week ended March 15, 2017.

It’s the thirteenth consecutive week of inflows for U.S. loan funds, for a total inflow of roughly $5.65 billion over that span.

Mutual funds drove the bulk of the weekly gain for a fourth consecutive week, with an inflow of about $518 million, while ETFs took in roughly $214 million.

The year-to-date total inflow is now $6.3 billion.

The four-week trailing average rose to $519 million, from $478 million last week, marking the 17th consecutive week in the black.

Total assets swelled to roughly $102.3 billion at the end of the observation period, which is the highest level since the week ended Sept. 24, 2014, when total assets were reported at $102.4 billion.

The change due to market conditions this past week was a decrease of $4 million. ETFs represent about 13.3% of total assets, at about $13.6 billion. — James Passeri

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Leveraged Loans: Covenant-Lite Share of Market Hits Record 77%

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April saw another record for covenant-lite issuance in the U.S. leveraged loan market.

By month-end, a full 77% of first-lien institutional loans outstanding were cov-lite, up slightly from the previous month, according to LCD.

The cov-lite market share has grown steadily, from roughly 60% in 2015, as retail investors and CLOs flooded the market with cash, looking to take advantage of the floating rate asset class amid rate hikes by the Fed.

Cov-lite loans have been in the spotlight over the past few years as their share of the market has grown. Detractors say these deals – which are structured akin to high yield bonds, offering less protection to lenders – could significantly impact recoveries when the current, long-running, issuer-friendly credit cycle turns.

In 2007, before the financial crises and at the end of the last credit cycle, cov-lite loans accounted for roughly 20% of U.S. leveraged loans outstanding. – Staff reports

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S&P Global: Europe’s Leveraged Finance Market Could Ride High Into 2019

Europe’s leveraged finance market is likely to stay buoyant for at least the rest of 2018, and probably the best part of 2019, says S&P Global Ratings in a report titled “How Long Can Europe’s Leveraged Finance Market Bonanza Last?

“As long as Europe’s growth cycle remains on track and is supported by quantitative easing and exceptionally low rates, we believe the operating environment is likely to be supportive,” said S&P Global Ratings in the report. “This is despite a number of potential problems that could trigger a turn in the market, most of which are external.”

The agency goes on to say that after €94 billion in high-yield bond issuance and €120 billion of leveraged loan issuance in 2017, market volumes are holding up in 2018, with €30.1 billion in bonds and €41.2 billion in loans issued in the first four months of the year.

The report states that causes for optimism include the improved credit performance of European corporates in recent months — with rating downgrades versus upgrades for high-yield issuers moving close to being balanced — and that this is backed by a macro environment that is supportive of operating performance, cheap funding conditions that are boosting the interest-coverage ratio, and a relatively prudent financial policy. Leverage has increased, but Europe sees less shareholder-friendly activity than in the U.S., where dividend payments and share buybacks tend to be a more prominent feature, S&P Global Ratings adds.

Another positive is the debt maturity profile, which gives companies some breathing space. Many issuers opportunistically refinanced their debt leveraging in the past year’s very favourable conditions, and debt maturities don’t pick up until 2021, thereby mitigating short-term risks, the agency adds.

“All this indicates to us that the tide is not yet ready to turn in Europe in 2018, and perhaps not even in 2019,” says the report. “As a result, we expect the corporate default rate in EMEA to remain very low at 2.5% by the end of 2018.” — Luke Millar

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Free Research – 17th Annual European Leveraged Finance & High Yield Conference

S&P Global was pleased to present recently its 2018 European Leveraged Finance & High Yield Conference: How Close Are We To the Top Of The Cycle?

europe PE

The conference featured a presentation by LCD’s Taron Wade regarding the intense institutional investor demand that is shaping the speculative-grade debt markets. The charts backing that presentation detailed trends and developments driving today’s market, including

  • European M&A activity, by specific use of proceeds
  • Trends in buyouts
  • Direct lending’s effect on the leveraged finance market
  • Yields on leveraged loans, Europe vs U.S.
  • The accelerating European CLO market
  • New issuance vs investor demand, European leveraged loan market
  • The increasing reliance on cross-border loan financing
  • The equity component of LBO financings (above)
  • … and, of course, the surge of covenant-lite loan issuance

The presentation also includes a panel discussion on risk of disruption in the credit cycle, a conversation regarding green investing, and a separate panel discussion on structural features and/or risks in today’s finance market.

You can download the slides backing Taron’s presentation here.

You can view the conference here. 

Both are complimentary, courtesy S&P Global Market Intelligence and LCD.

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Leveraged Loans: Covenant-Lite Issuance From Riskiest Borrowers Surges in Europe

b minus european loan issuance

Leveraged loan issuance from lower-rated borrowers has been driving activity in Europe lately (link), with covenant-lite deals leading the way.

As of April 20, in fact, there was €8.16 billion of cov-lite loans from issuers rated B- outstanding, according to LCD’s European Leveraged Loan Index (ELLI). That’s up from €6.58 billion at the end of March and from €3.51 billion one year ago.

Cov-lite loans have been in the spotlight of late as their use has skyrocketed, first in the U.S., then in Europe. These credits are structured akin to a high yield bond in that they feature incurrence covenants, as opposed to the more restrictive maintenance covenants.

With an incurrence covenant a debt issuer would have to meet a specific financial test only if it wanted to undertake a particular action (like borrow money to fund a dividend to a private equity sponsor, for instance). Under a maintenance covenant the issuer would need to meet regular, specific financial tests, even if it did not want to undertake that dividend deal.

Cov-lite detractors say these transactions could put investors and lenders in a precarious position, as they might not become aware if a borrower is nearing financial distress until a point where traditional remedies are no longer viable. – Staff reports

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US Leveraged Loan Fund Inflow Streak Hits 11 Weeks, $4.3B

US loan funds

U.S. loan funds recorded an inflow of $494 million for the week ended May 2, according to Lipper weekly reporters only. This follows last week’s inflow of $264 million and marks the eleventh consecutive week of inflows for U.S. loan funds, for a total inflow of roughly $4.3 billion over that span.

Mutual funds again led the gains this week, with an inflow of $373.5 million, while ETFs reported an inflow of about $121 million.

The four-week trailing average rose modestly, to $441 million, from $389 million last week, marking a fifteenth consecutive week in the black.

The year-to-date total inflow is now roughly $5 billion.

Total assets rose to roughly $101 billion at the end of the observation period, which is the highest level since the week ended Sept. 24, 2014, when total assets were reported at $102.4 billion. The change due to market conditions this past week was an increase of $205 million. ETFs represent about 13% of total assets, at about $13.3 billion. — James Passeri

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Tesla High Yield Debt Slides on 1Q Update, and as Musk Dodges Model 3 Questions

Tesla’s debut bonds fell this morning after the company released mixed first-quarter results after the closing bell yesterday. CEO Elon Musk, on the post-earnings call with analysts late yesterday, also raised eyebrows with his evasion of analyst inquiries into developments surrounding the electric car manufacturer’s critical Model 3 sedan.

The 5.3% notes due 2025 were changing hands as low as 87 today, indicating a roughly 2.25-point decline on the day, according to MarketAxess. The notes priced at par in August 2017 and plumbed lows of 86 in early April following a March 27 ratings cut by Moody’s, which at that time also lowered the issuer’s outlook to negative, from stable, citing negative free cash flow, liquidity pressures, and a “significant shortfall in the production rate of the company’s Model 3 electric vehicle.”

Tesla now says it will become cash flow positive in the second half of 2018 as the company ramps up production and deliveries of the Model 3 sedan, which the issuer said yesterday is “already on the cusp of becoming the best-selling mid-sized premium sedan in the U.S.”

Bruce Clark, lead auto analyst and Moody’s senior vice president, said today that Tesla “showed important progress by sustaining Model 3 weekly production above 2,000 units for three consecutive weeks.”

“Nevertheless, the company remains in an intense ‘learn-as-they-go’ process while attempting to reach production efficiencies necessary for a Model 3 production rate of 5,000 per week, a Model 3 gross margin of 25% and breakeven cash flow,” Clark added. “We continue to expect that Tesla will need to raise new capital approximating $2 billion—in the form of equity, convertible notes, or debt—in order cover a cash burn during 2018, and to refund a total of $1.3 billion of convertible debt that matures in late 2018 and early 2019.”

On yesterday’s conference call with analysts, discussing the subject of Model 3 reservations and capital requirements, Musk proved evasive, declining to answer and making the statements: “These questions are so dry,” “they’re killing me,” and “Boring questions are not cool. Next.”

Musk also said on the call that he is “quite confident about achieving GAAP net income and positive cash flow in 3Q,” highlighting that Model 3 gross margins should approach a range of about 20% by the end of 2018, as part of a steady trajectory toward a 25% target.

Tesla said first-quarter revenue totaled $3.4 billion, topping analyst expectations by roughly 3.3%, based on consensus data compiled by S&P Global Market Intelligence. The company booked a pretax loss of roughly $779 million for the quarter, slightly wider than the consensus estimate of $764 million.

Tesla also reduced its expectations for 2018 capital expenditures to less than $3 billion, from guidance of more than $3.4 billion previously. “Ultimately, our capex guidance will develop in line with Model 3 production and profitability,” the company said. “We will be able to adjust our capital expenditures significantly depending on our operating cash generation.”

On the liquidity front, Tesla reported $2.7 billion in cash at the end of March, down $700 million from a $3.4 billion cash balance at the end of 2017.

Tesla bonds have been pressured over the past several months as adjusted EBITDA and free cash flow for the past two quarters fell shy of analyst estimates. The company placed its debut 2025 offering in August to bolster its balance sheet and for general corporate purposes ahead of the launch of the Model 3, its first electric car designed for the mass market. The $1.8 billion tranche size was upsized from $1.5 billion.

Corporate and bond ratings are B–/B3 and B–/Caa1, respectively, with negative outlooks by S&P Global Ratings and Moody’s, and 3 recovery rating on the unsecured notes by S&P Global.

Tesla is a Palo Alto, Calif.–based manufacturer of electric vehicles as well as energy storage and solar products. — James Passeri/Jakema Lewis

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US Leveraged Loan Default Rate Dips to 2.37%

leveraged loan default rate

Despite a bankruptcy filing from U.S. footwear/apparel company Nine West, the default rate of the S&P/LSTA Leveraged Loan Index eased to 2.37% in April from a three-year high of 2.42% at the end of March. The slight decline reflects the fact that Payless ShoeSource rolled off the 12-month calculation.

The current rate, though still close to the three-year high, remains well inside the 3.1% historical average. By number of issuers, the rate now stands at a 16-month high of 1.95%, versus 1.93% in March. – Rachelle Kakouris

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Where is the Leveraged Loan Market Now? 10 Years After the Credit Crunch

It’s been 10 years since the financial crisis, and since the famously abrupt end to the last credit cycle. The global loan markets have rebounded since then, of course, with the current long-running cycle marked by soaring issuance, record-low yields, intense investor demand for loan paper, looser covenants, and a stubbornly low default rate (though it is rising).

This cycle will end sometime, obviously, and the 10-year anniversary of the onset of the last crisis, along with the continued frothiness of the current market, has prompted much talk lately of how today’s leveraged loan world differs from the pre-crisis days of 2007–08.

To help address that issue, LCD and S&P Global Market Intelligence recently presented a live event—The Global Credit Markets: 10 Years after the Credit Crunch—featuring analysis from leveraged loan and high-yield bond market veterans, along with LCD analysts (you can replay that complimentary event here).

These charts, courtesy LCD’s Marina Lukatsky and Ruth Yang, are part of that presentation.

To compare the leveraged loan market’s standing recently versus before the credit crisis, let’s set the stage with some headline numbers.

  • Size: First off, the market has grown tremendously. Per the S&P/LSTA Index, the size of the U.S. leveraged loan market is nearly $1 trillion—that’s up 72% from 10 years ago—and now comprises almost 1,000 issuers. While much of this expansion has been home-grown, the globalization of the markets is evident. Roughly 9% of outstanding loans now are courtesy companies domiciled in Europe, versus just 3% before the credit crisis. The surge in Yankee supply has largely stemmed from companies expanding operations—and having a greater need to match dollar cash flows—and from increased global M&A activity.
  • Issuers: Predictably, the industry make-up of the loan market has shifted. Tech companies now account for the biggest slice of the Index, followed by Services and Healthcare. Pre-crisis, the loan issuer base was dominated by Utilities, Automotive, and Publishing (each accounted for a slim 2% of loan outstandings at year-end 2017).
  • Spreads: Ten years ago loans carried an average nominal spread of roughly L+250; they offered L+340 at year-end 2017. However, looking at the discounted spread to maturity, which takes into account the secondary price, the two periods are only 10 bps apart, L+370 then versus L+380 at YE 2017. The average bid of the Index has grown over the last 10 years, from around 94 to 98, with roughly two-thirds of outstanding loans now priced at par or higher. Of course, by the end of 2007, market conditions had deteriorated significantly from the beginning of the year. Institutional loan issuance retreated from a then-unprecedented $143 billion in 2Q07 to just $46 billion in 3Q07, and the average bid of the Index fell from near-par levels to the 94 area (boosting the discounted spread to L+370).
  • Credit quality: While the discounted spread is in the same ballpark now as it was in 2007, there are some concerning signals in the current market. First, let’s consider credit quality: About half the loan market is made up of riskier borrowers, those rated B+ or lower. In contrast, in 2007, only 32% were B+ or lower. Second, 75% of the outstanding market is now covenant-lite. Ten years ago, only 17% was cov-lite.

Given that the leveraged loan issuer base is currently populated by more lower-rated credits and cov-lite structures than it was 10 years ago, let’s look at how lenders get compensated for risk today, versus 2007.

The following graphic details spread-per-unit-of-leverage (SPL) for outstanding loans (the 2008 numbers are literally off the charts). To calculate this value, LCD divides the current discounted spread of the Index by pro forma debt/EBITDA ratio at closing of each loan. Again, the discounted spread was roughly the same at the end of 2007 as it was at the end of 2017. However, transactions syndicated 10 years ago were riskier, with debt/EBITDA averaging 5.7x, and with many of those deals pushing the boundaries of acceptable leverage levels. After the financial crisis, debt/EBITDA retreated, and has stood at around 5x over the last five years.

As a result, loan investors in 2017 were better compensated for risk, as measured by SPL, than in 2007: 76 bps per turn of leverage recently versus 65 bps per turn of leverage in 2007.

That being said, we’ll note that this 76 bps is a significant step-down from levels seen just two years earlier. While leverage has remained largely stable, discounted spreads have tightened, from around L+625 in 2015 and L+441 in 2016, on the back of intense demand for loans from CLOs and retail funds. As a result, SPL has dipped to the recent 76 bps from roughly 120 bps in 2015 and 90 bps in 2016.

Let’s take another look at risk, this time using current leverage and interest coverage ratios of outstanding loans at each year-end (based on borrowers that file publicly).

At the end of 2017, borrowers tracked by the S&P/LSTA Index had an average debt/EBITDA ratio of 5.3x. That’s up slightly from the 5x in 2008 but is below the recent high of 5.5x in 2014. Moreover, the interest coverage ratio, which measures how well a borrower can meet its interest payment obligations, had grown to 4.8x in 2017, the highest level in 10 years (and up from just 3.2x in 2007). Looking at this metric over a shorter period, back to 2014, borrowers had both higher debt multiples and lower interest coverage.

Moreover, for the new-issue market proper, the days of astronomical leverage are long gone. While there are a few deals in the 7x area (about 5% of the market), this is clearly the upper limit of leverage. In 2007, roughly a quarter of all LBOs were levered over 7x, and roughly two dozen were at 8x or higher.

Moving on to the secondary market, the following chart shows the average bid of outstanding loans at each year-end, and how this average breaks down by sector.

Ten years ago, all sectors priced within a tight band of about 10 points, between 86 and 96, with sectors such as Building & Development and Home Furnishings underperforming, while the Oil & Gas and Telecom sectors outperformed. With the crisis, prices plummeted across the board—regardless of sector fundamentals—as the loan market virtually shut down. Top-performing sectors dipped to the low-70s while underperforming sectors dropped to the mid-40s.

In the years after the crisis, however, this pricing gap narrowed. Over the last five years prices have held within a relatively tight 10-point band, with a few exceptions. In 2011–2013, the weakest sectors were Publishing and Transportation, and in 2014 Oil & Gas loans suffered as plunging oil prices put much of the energy sector in dire straits. In 2015–2016, O&G, Metals, and Retailers lagged. In fact, looking at the last three years—excluding these three weakest sectors—the average bid between the top and bottom sectors is just six points (from the mid-90s to slightly over par). In 2010, by contrast, this gap was roughly 13 points.

It is important to note, however, that this handful of troubled sectors has a relatively low concentration in the loan market. O&G loans account for 3% of the Index, with Retail at 5%. However, Healthcare, another sector on the watch list amid macro-level concerns, accounts for a relatively hefty 8%.

It’s impossible to talk about credit cycles—for the loan market, certainly—without focusing on LBOs.

Private equity firms sat atop a mountain of dry powder by the end of 2017, and were understandably eager to put that cash to work. This contributed to an increase in purchase price multiples, which rose to an all-time high by year-end, to 10.6x, from 9.7x before the crisis. That spike did not result from increased debt, however. It’s because sponsors were putting more skin in the game. Out of that 10.6x multiple in 2017, 5.7x came from debt, while 4.9x came from the sponsors’ equity contribution. To put it another way, the equity component represented 46% of the purchase price. Ten years ago the equity component was just 36% of the purchase price, or 3.5x EBITDA, while the debt multiple stood at 6.1x.

Turning to a more forward-looking view, this variation of LCD’s Maturity Wall chart shows the amount of near-term maturity, i.e., loans coming due in the next three years, at each year-end. The maturity wall is important, of course, because for a default to occur an issuer must typically be unable to service its debt or refinance or repay at maturity. In this respect, issuers within the Loan Index are operating with relatively healthy coverage cushions (as detailed earlier) to absorb any short-term shocks.

As of the end of last year, $102 billion of loans will come due between 2018 and 2020, representing just 11% of all outstanding loans. This is on par with the share seen over the last five years, meaning borrowers have done a sound job at managing the near-term maturity wall by opportunistically refinancing, repaying, or extending debt into the future.

This bodes well for low default rates. And in LCD’s quarterly U.S. Default Survey, conducted in March, portfolio managers again pushed out their forecast for when the U.S. leveraged loan default rate—2.4% at the end of March—will top its 3.1% historical average. Nearly two-thirds of the survey respondents (64%) expect this to be a 2020 event, while those expecting a breach in 2019 slid to 27%, a dramatic shift from the 93% with that expectation at the third-quarter 2017 reading.

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April Performance by Industry, US High Yield Bond Market

High yield expert Martin Fridson, on industry performance in the U.S. bond market (part of Marty’s weekly commentary for LCD):

Telecommunications led the 20 major high-yield industries in return in April, doubling the performance of the second-place finisher, Energy. Notwithstanding the outsized returns on Sprint issues (word emerged last month that Spring and T-Mobile were discussing a merger), the Telecom rally was quite broad-based. The non-Sprint portion of the ICE BofA Merrill Lynch High Yield Telecommunications Index returned 2.26%, still well ahead of runner-up Energy. As usual, Energy’s performance was closely tied to crude oil prices. As measured by West Texas Intermediate futures, the price surged from $64.87/bbl., to $68.57/bbl. in April.

Automotive & Auto Parts finished dead last, as it did in March. This time the industry’s return was strongly skewed by a single issuer, American Tire Distributors, which lost distribution rights for the Goodyear, Dunlop, and Kelly tire brands. The ATD 10.25% notes due 2022 accounted for just 2.3% of the ICE BofA Merrill Lynch High Yield Automotive & Auto Parts Industry’s market value, but its –47.12% return dragged down the –0.60% return for the rest of the group all the way to –1.69%. That being said, Automotive & Auto Parts was the only major industry to post a negative return in April. 

Mary’s full weekly analysis is available to LCD News subscribers here. 

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