An update on the US Leveraged Finance market for Australian issuers - published by Kanga News, featuring Peter Graf

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FEATURE
The US high-yield market has come under scrutiny in recent times after
significant spread widening caused a liquidity crunch and consequent high-
profile fund failures. Market conditions have clearly taken a serious knock, but
Australian-based intermediaries insist transactions with strong underlying credit
stories can still be executed in the US.
B Y H E L E N C R A I G
L
ate in 2015, it became apparent that the hunt for
yield that had fuelled the US speculative-grade
market was in the process of unwinding. The
correction was put into sharp relief on December
9, when Third Avenue Management (Third
Avenue) shuttered its Focused Credit Fund after it
became unable to meet redemption requests. The
fund had US$788 billion in assets under management at closure,
having managed US$3.5 billion as recently as July 2014.
The Third Avenue fund appears to be an outlier at this stage.
But it is not the only fund to fail, or to return assets to clients due
to its manager’s view that there are insufficient investable options
of suitable credit quality. Bank of America Merrill Lynch high-
yield indices were down in 2015 for the first time since 2008, and
downgrade and default rates have both spiked (see p18).
Meanwhile, volatility characterised a range of global risk
markets in the first few weeks of 2016. The consequent flight-
to-quality bid saw the US high-yield and leveraged-loan markets
suffer a particularly nervy start to the year. Spreads have been
driven wider, meaning issuers that do not have to be in the market
have elected to wait on the sidelines for stability and execution
certainty to return.
The high-yield loan and bond markets have been under
pressure since mid-2015. Alok Jhingan, director and head of
leveraged and acquisition finance at Deutsche Bank in Sydney,
describes last year as a tale of two halves. “There was a lot of
issuance in first half but credit spreads widened dramatically in
the second, causing the market to slow,” he explains.
Caution reigns at the start of 2016, as US fund managers
reassess both their cash levels and their participation in
primary-market transactions. Bankers tell KangaNews that funds
which had been holding 5 per cent of their assets in cash are
often now holding 10-15 per cent. “This is massive,” Jhingan
says. “Funds are also less willing to participate in deals where
pricing is deemed to be inappropriate. They are of the view
that buying a deal in primary may not be attractive when they
Setting the record
STRAIGHT
VOLUME(US$BN)
SOURCE: CREDIT SUISSE JANUARY 2016
180
160
140
120
100
80
60
40
20
0
US HIGH-YIELD BOND ISSUANCE BY QUARTER
129
109
123
102
163
106
101
91
48
92
69
45
2013 2014 2015
Q2 Q3 Q4Q1
VOLUME(US$BN)
SOURCE: CREDIT SUISSE, STANDARD & POOR’S RATINGS SERVICES JANUARY 2016
160
140
120
100
80
60
40
20
0
US TERM-LOAN B ISSUANCE BY QUARTER
149
128
57
117 113
85
100
92
66
89
43
54
2013 2014 2015
Q2 Q3 Q4Q1

2. 2 3
can pick it up for less than par in
the secondary market.”
POINTS OF LIGHT
H
igh-yield issuance has not
ground to a complete
halt, though. A number
of new transactions priced in the
first weeks of 2016, including one
– from Pinnacle Foods – which was six-times oversubscribed
and consequently reverse flexed.
Peter Graf, in the debt capital markets team at Credit Suisse in
Sydney, says other deals have resulted in similar outcomes. “New
high-yield and TLB [term-loan B] issuance from well-known
borrowers or those not linked to the commodity sector has been
well received in the first few weeks of 2016, with a number of
transactions tightening final margins from price talk.”
Even so, Credit Suisse data confirm that the third and fourth
quarters of last year saw US high-yield bond volume fall to its
lowest quarterly level since the beginning of 2013 (see chart on
facing page). This fall made a significant dent in annual volume
as the market saw US$322 billion of issuance in 2015, compared
with US$424 billion in 2013 and US$432 billion in 2014.
The year-on-year drop in TLB issuance is even greater than
high yield bonds – and it has been sustained. The last quarter of
2014 and all four quarters of 2015 represent the bottom five for
issuance in the past three years (see chart on facing page).
However, Graf argues that the recovery outlook is better for
loan products than bonds. With interest rates on the rise, as a
largely fixed-rate market bonds will see an increase in new-issue
coupons. On the other hand, floating-rate TLBs will be more
attractive in the short-to-medium term on a relative basis.
“It is fair to say US market participants aren’t as optimistic
about a full high-yield bond recovery taking place in the coming
months, but in TLB, for the right industry, the general mood is
better,” Graf tells KangaNews.
Jhingan’s short-term summary is cautious. He says: “High-
yield volume in the first three weeks of January were at levels
consistent with the period immediately following the financial
crisis. The market is in price-discovery mode.”
However, the bankers both deny suggestions of a meltdown
and argue that longer-term recovery prospects are good. Jhingan
continues: “Sponsors globally have a lot of cash to put to work
and refinancing activity is expected to pick up in the corporate
bond space. Deutsche Bank’s expectation is for a relatively flat
10-year US Treasury curve, which will help.”
FLIGHT TO QUALITY
T
he extent of spread widening in early 2016 varies
between the various high-yield options, but it clearly
represents a drastic repricing since the heady days of
2014. Until the middle of last year, high-yield leveraged buy-out
(LBO) loans were pricing in the area of Libor plus 350-400
basis points, with a typical 75-100 basis points Libor floor,
Jhingan tells KangaNews. They have since risen to around Libor
plus 475-500 basis points.
Jhingan says yields on high-yield LBO bonds in the US have
risen even more significantly. “Where yields were 7.5-8 per cent
in the middle of last year they are now close to 9.5-10 per cent,”
he reveals. “This compares with record tights in the 4.75 per cent
area achieved in mid-2014.”
Flight to quality within the high-yield asset class has played out
into 2016, Jhingan continues, as investors flock to safer sectors
and stronger-rated credits and deals. “We continue to see solid
demand for correctly priced transactions in the high-single-B and
double-B bands,” he says. “Further down the rating spectrum
it may get a little trickier, while commodity- and energy-sector
exposed transactions will be challenged to find demand in the
present environment.”
This may not mean the doors are closed to Australian credits,
but issuing will likely prove a challenge. Jhingan explains that
investors – particularly less regular buyers of Australian credit
– are likely to be very cautious when considering any allocation,
regardless of sector, particularly to first-time issuers. In other
words, it is not just commodity- or energy-related credits that are
deemed risky.
“The contagion has spread much more widely, making it
challenging for Australian credits in the current environment,”
Jhingan suggests. “This does not mean that deals will not get
done. They may just require more investor education and a
different price point in the current environment.”
Economics are likely to be especially unappealing for issuers
seeking Australian dollars. “Credit spreads are already significantly
“It is fair to say US market participants
aren’t as optimistic about a full high-yield
bond recovery taking place in the coming
months, but in TLB, for the right industry,
the general mood is better.”
P E T E R G R A F C R E D I T S U I S S E
VOLUME(US$BN)
SOURCE: CREDIT SUISSE, STANDARD & POOR’S RATINGS SERVICES JANUARY 2016
500
450
400
350
300
250
200
150
100
50
0
US LEVERAGED-LOAN ISSUANCE
325
388
443
2007 2008 20092006 2011 2012 20132010 2015 2016*2014
*estimated
361
274
291
231
156
72
39
240

3. 2 4 | K A N G A N E W S F E B / M A R 2 0 1 6
FEATURE
wider and it will likely cost Australian issuers another 2-3 per cent
to swap back to local currency,” Jhingan says.
However, Graf argues that periods of uncertainty will not
necessarily keep Australian names shut out of the market –
although he acknowledges that access will be sector-specific. “It
will be quite difficult for lower-rated issuers in more challenged
industries, such as resources, to access markets. However, there
is still plenty of opportunity for an appropriately structured
transaction in such industries and, of course, issuance not linked
to commodities – such as the retail, consumer and healthcare
sectors – and industrials.”
Australian issuers are likely to find more appealing funding
from their domestic banking sector in this environment. “We are
seeing banks’ cost of funding increase – by 20-30 basis points
in 2015 – but there is little evidence of this being passed on,”
Jhingan says.
PATH TO RECOVERY
B
ankers argue that market conditions at the start of
2016 may already signify that the real pain has passed –
though the predicted recovery is a slow one. Graf says
Credit Suisse’s fixed-income research team expects US dollar
high-yield issuance to decrease by approximately 15 per cent in
2016 even on last year’s already-reduced level.
“Higher refinancing costs and volatility in commodity prices
will probably weigh on 2016 issuance,” Graf tells KangaNews. “We
expect refinancing-related issuance will decline by 20 per cent
given the end of record-low interest rates in the US. If recent
volatility in commodity prices continues it may negatively affect
issuance. But, despite these factors, issuance for names not linked
to commodities is expected to remain very strong.”
Jhingan also believes issuance of high-yield bonds and loans
will likely fall by 10-15 per cent in 2016, with the bulk of the
discomfort likely to be felt in the first part of the year. “Market
participants expect declining volume to be particularly harsh in
the first quarter and then, all other factors being equal, a recovery
to begin in the second quarter and continue throughout the
remainder of the year.”
The outlook is similar in the leveraged-loan space. The 2013
calendar year marked the cyclical peak in leveraged-loan issuance
– at US$443 billion – and there has been a downward trend
since then (see chart on p23). “We expect leveraged-loan volume
to continue this trend,” Graf comments. “In 2016, we expect
issuance to decline by 12 per cent to around US$240 billion from
US$274 billion in 2015. But is important to note that the lower
level is still comfortably
above annual issuance from
2008 to 2011.”
NO REFINANCING
DRIVER
T
here is a less
headline-friendly
reason for the
anticipated fall in issuance in 2016, which is that there are
limited prospects for opportunistic refinancings. These have
been a significant driver of market activity in the historically
low interest-rate and yield environment, as issuers have taken
the opportunity to lock in cheap funding and come back to
refinance them as yields have continued to fall. Refinancing
activity reached its peak in 2013 at US$218 billion and has
progressively fallen to US$140 billion in 2014.
Graf says two good indicators of refinancing activity – the
percentage of the market trading to an early call or at a yield
less than its coupon – are at low levels. “The impact is most
pronounced in the triple-C-rated category, while plenty of
opportunities remain in the single- and double-B-rated area.”
The largest driver for the lighter issuance forecast into 2016 is
the likely refinancing-related issuance slowdown, Graf confirms.
Credit Suisse expects this activity to decline further next year, by
around 30 per cent.
Intermediaries coalesce around the opinion that, with little
prospect for opportunistic refinancings, activity is likely to be
limited to corporate M&A, at least in Q1. There is more cause
for optimism in the M&A space, they say, with a pending pipeline
of announced but as yet unfunded transactions. This should also
leave the offshore high-yield markets open to Australian issuers
with financing needs.
PLOUGHING ON
G
iven the fact that issuance windows can open and close
quickly in the sub-investment-grade space, issuers may
not have to wait too long for an ideal opportunity,
Graf insists. “Lenders and investors generally do a good job
in allocating wider pricing to where they feel the volatility
and uncertainty is stemming from,” he tells KangaNews. “This
means deals which have a well-explained, positive and strong
underlying credit story should still be able to obtain competitive
pricing.”
Against this backdrop, Graf says Credit Suisse’s advice
to its clients is to ‘hurry up and wait’. He explains: “Potential
issuers should carry out the preparatory background work on
documentation, due diligence and syndication strategy. This
preparation enables an issuer to be opportunistic and hit the
market as quickly as possible when the opportunity allows.”
Jhingan adds: “Corporate M&A activity and refinancing will
continue to be key drivers of high-yield volume in 2016 and LBO
activity will remain significant, as sponsor dry powder needs to be
put to work.” •
“Market participants expect declining volume
to be particularly harsh in the first quarter and
then, all other factors being equal, a recovery
to begin in the second quarter and continue
throughout the remainder of the year.”
A L O K J H I N G A N D E U T S C H E B A N K