The low interest rate environment in the United States and significant competition amongst banks and other lenders continues to feed into the leveraged loan approval frenzy. $308 billion gross institutional loans were issued the first quarter of this year; this is nearly triple the issuance the last quarter of 2020, $116 billion and significantly above the previous high of $202 billion the first quarter of 2020. It makes sense that so many companies want to take advantage of cheap funding. The inaugural ‘Fitch U.S. Leveraged Finance Market Insight Report,’ shows that repricing and refinancing transactions made up 74% of first-quarter total issuance; mergers and acquisition (M&A) and dividend recapitalizations represented the remainder.
Presently, the institutional leveraged loan market stands at $1.5 trillion. Almost 40% of leveraged loans are in the healthcare/pharmaceutical, technology, and services/miscellaneous sectors. As readers who follow my columns know, I have long been worried about the rising indebtedness of American corporations. Moreover, with over 80% of total leveraged loans being covenant-lite, should any of these borrowers were to default, lenders will have little in protection to sustain financial losses. Over 90% of the loans in the buildings and materials, chemicals, industrial manufacturing, insurance, and technology, and telecommunications sectors are covenant-lite.
According to Eric Rosenthal, Senior Director of Leveraged Finance at Fitch Ratings, “high yield volume tallied a record $143 billion during 1Q21, up 97% compared with the first quarter of 2021. The pandemic curtailed high yield bond issuance last March; however, volumes rebounded quickly and reached record monthly levels in the remainder of 2020.”
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As of April 9, issuance started off strong at $16 billion; this continues “the trend of monthly issuance averaging a robust $41 billion since last April. Energy generated $24 billion, or 17%, of 1Q21 issuance while banking and finance (at 9%) and retail (at 8%) also posted more than $10 billion of volume,” said Rosenthal. Loans for refinancing accounted for the majority of first quarter 2021 issuance; however, the high yield market grew to $1.45 trillion from $1.42 trillion at the end of 2020. Prior to the pandemic, the market stood at $1.22 trillion.
Over 70% of the leveraged loan universe is rated B or lower. Given the severity of the pandemic, it is not surprising that the leisure and entertainment sectors have been the most adversely impacted. At 40%, these sectors have the highest percent of ‘CCC’ through ‘C’ rated issues.
Also troubling is that loan documentation continues to leave much to be desired by people like me who believe in the safety and soundness of the banking system in order to protect ordinary taxpayers. Fitch’ Covenant Review’s Composite Documentation Score reached 3.70 in March; this is the weakest level since Fitch began tracking it in 2016. The score has deteriorated from 3.17 in May 2020 at the height of the pandemic. “Investors chasing new deals in the loan market enables borrowers and sponsors to tilt credit agreements more in their favor,” explained Rosenthal.
Bank regulators certainly know that banks continue to underwrite covenant-lite loans with weak documentation. The Federal Reserve’s Senior Loan Officer Opinion Survey on Bank Lending Practice in January of this year shows that a “modest shares of large banks reported having eased standards to large and middle-market firms.” Moreover, these banks expect to keep easing standards the rest of this year. In my view, easing underwriting standards while we are still in a pandemic is not a good idea at all. Bank regulators should ask these banks to increase their regulatory capital and to double check how liquid they are. If borrowers with covenant-lite and weak documentation default, investors, regulators, and not to mention taxpayers are going to want to make sure that these banks can withstand unexpected losses.
Note: Here are a few articles on corporate debt and zombie companies by this author; all of her articles are on her Forbes page.