Key points to remember
US consumer goods inflation hit a 40-year high in June 2022 of 9.1%
Since January, the US Federal Reserve has raised interest rates four times
High-yield issuance for the six-month period fell 76% year-on-year as investors exited fixed-rate debt
Lending markets were also affected as prices and initial issue discounts widened
Lenders and borrowers in US leveraged financial markets have had to recalibrate expectations for pricing and issuance volume in 2022 in the face of rising inflation and interest rates.
The abundant liquidity that fueled the leveraged loan and high-yield bond markets in 2021 dried up in the first half of 2022, as macroeconomic uncertainty, events in Ukraine, soaring prices supply chain bottlenecks related to COVID-19 have driven up the prices of goods and services and left central banks around the world with limited alternatives to keep interest rates low .
Figures from the US Department of Labor showed consumer goods inflation rose 8.5% in March, the biggest year-over-year increase since 1981. In response, the same month, the US Federal Reserve raised interest rates for the first time in three years to fight inflation, raising rates by 0.25 percentage points.
In early May, the Fed hiked 0.5 percentage points and in June, as inflation hit a 40-year high, interest rates were raised another 0.75 percentage points, the biggest increase since 1994. In July, with inflation remaining stubbornly high, the Fed raised rates again by 0.75 percentage points.
More rate hikes are on the way, and liquidity is also expected to tighten as the US central bank shrinks its balance sheet by US$9 trillion.
High yield bonds are under pressure
Since January, the US Federal Reserve has raised interest rates four times, bringing its key rate to a range of 2.25-2.5%.
The impact of rising interest rates and inflation in US leveraged financial markets has been felt the hardest in high yield bonds.
As fixed-rate instruments, high-yield bonds are vulnerable to rising rates, which eat away at bond investors’ returns. This has caused significant amounts of capital to be withdrawn from high yield bonds – data from Lipper shows that in the first four months of the year, US$27 billion was withdrawn from the asset class.
This has resulted in a difficult market for issuers. According to Debtwire Par, high-yield bond issuance fell 76% in the first half of 2022, year-on-year, to $63.6 billion.
High-yield bond issuers that entered the market paid higher rates to convince investors to back their offers. Used-car retailer Carvana, for example, paid a 10.25% coupon to land a US$3.27 billion eight-year unsecured bond in April to fund the acquisition of the business. ADESA Physical Auction. For comparison, eight months earlier, in August 2021, Carvana tapped the market for an eight-year unsecured bond priced at 4.875%.
Dallas-based glass and glazing maker Oldcastle meanwhile paid a 9.5% coupon and offered a discounted issue price (92.12%) to investors on a $585 million secured bond used to finance part of its leveraged buyout by KPS Capital Partners.
Both Carvana and Oldcastle received ratings in the lowest bracket (CCC+ or lower) and, in a market characterized by low volumes, accounted for more than half of monthly issues in April. As a result of these two bond issues, average yields on senior secured and unsecured bonds rose from 5.71% in the first quarter of 2022 to 8.07% in the second quarter, according to Debtwire Par.
Even top-rated credits were affected by the volatile inflationary environment. BB-rated engineering and construction firm Global Infrastructure Solutions, for example, priced a ten-year US$300 million senior unsecured note at 7.5% and par, but saw prices in the secondary market fall to 88.7% of par, for an implied yield. of 9.25 percent.
Leveraged loans facing the challenge
The leveraged loan market has been shielded to some degree from macroeconomic headwinds as floating rate structures on loans rise in line with rising interest rates, but it has not been to the sheltered from the impact of these market fluctuations.
Through May 2022, leveraged loan funds had seen an 18-month streak of consecutive growth in assets under management, according to S&P and Lipper. However, from early May to the end of the week ending June 22, more than US$6 billion exited the market as investors became more risk averse.
Activity in the secured loan obligation (CLO) space – the largest pool of investors in leveraged loans – has also slowed, particularly in refinances. New CLO issuance is down 12% year-on-year for the year to end May 2022, while CLO refinancing issuance is down 94%. However, this could pivot again as things improve, as CLOs have proven resilient throughout the worst of the pandemic to date.
With the tightening of loan demand, loan prices have risen. According to Debtwire Par, average spreads on senior institutional term loans climbed to 4.31% in the second quarter of 2022, well above the average of 3.96% in the first quarter of 2021 and the average of 3 .74% recorded in the second quarter of 2021.
Despite some bleak headlines, the market is still open for business – Refresco Gerber raised a multi-currency loan package worth US$4.1 billion to support its takeover by KKR, while Therm-O-Disc secured a loan term B of US$360 million for its takeover by One Rock Capital Partners. While the lending space will undoubtedly regain momentum in the coming months, interest rates and inflation are resetting market expectations.