MUFG: Shifting dynamics at play in the leveraged loan market

Rising interest rates on certain leveraged loans are due to increasingly discriminating investors, according to officials at MUFG.

Grant Moyer, head of leveraged capital markets at MUFG, said that the interest rates are actually higher than what their issuers’ credit ratings appear to warrant.

MUFG provides financing and fixed-income advisory services to corporate clients and to private-equity sponsors.

Moyer said at a roundtable late last year that investors are doing more homework these days on loans that typically carry a higher risk of default than investment grade bonds. These investors are conducting thorough and more critical evaluations of lenders to better understand their business models and path to profitability.

The expectation for 2020 is for the appetite for leveraged loans to continue to grow and Moyer believes tightening credit spreads among issuers will reflect this trend.

MUFG’s Leveraged Capital Markets team says that low interest rates in the U.S. will promote attractive debt-funding costs for issuers and do little to diminish investor demand for higher yields and corporate debt.

The prospect of slowing global economic growth and the U.S. elections could prompt greater market volatility and affect leveraged loans.

As investor demand swells, MUFG predicts declining supply, greater bifurcation, higher-quality demand from collateralized loan obligations (CLOs) and shifting borrowing terms.

MUFG’s Leveraged Capital Markets team expects leveraged loan supply to decline by roughly 11% from 2019 on the back of lower M&A volume due to high valuations.

Secondly, the performance divide between high and low rated issuers will continue to widen. The team said investors will show a preference for B3-rated issuance or higher, especially as CLOs seek to limit their exposure to lower-rated leverage loan issuers to protect themselves from downgrades.

The CLO market, however, represents the largest source of demand for leveraged loans as these structured products bought 70% of new issuances in 2019, according to MUFG. They added that with more than half of the Leveraged Loan Index rated B or lower, CLO managers will likely remain cautious in 2020.

Meanwhile, sponsor-backed loan issuance such as those issued by private equity sponsors of buyouts accounts for roughly 60% of the leveraged loan market. Officials expect that with the record amount of cash on hand at private equity funds, M&A volume will likely rise this year.

Large private-equity sponsors have pushed the limits of traditional credit protections over the past few years, MUFG officials said. This has resulted in greater flexibility to incur additional debt, make adjustments to EBITDA and make restricted payments.

MUFG officials concluded that if economic growth does slow corporate borrowers and private equity sponsors may find that larger equity contributions may not be sufficient to ensure recovering in the event of a default.

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