CJ Doherty: Welcome to the Lending Lowdown. I'm CJ Doherty, head of Market Analysis. And I'm joined by Maria Dikeos, head of Global Loans Contributions here at LSEG. We're excited to bring you our 8th podcast in the series. So thank you everybody for tuning in today. Today we're going to look at the state of the US leveraged loan market in early 2023, following what was by all accounts a tough 2022, which was marked by economic uncertainty, volatility, the highest inflation in 40 years, and interest rate hikes to try and counter that inflation. And so Maria, I think it's fair to say that leveraged loan deal flow faces challenges. In 2023, lending was down sharply last year. Institutional loan volume was off by a whopping 64%. And so it's by no means straightforward as to what's ahead this year.
Maria Dikeos: Yes, I think that's exactly right, CJ. Based on what we're hearing, lenders are certainly hoping for gradually improving market conditions, though there may be some jolts at times, given macroeconomic news. I think that overall there's a feeling that growth will be sort of a positive upward momentum. So much of the 2022 leverage calendar was defined by deal overhang, and we expect the market to continue to make inroads in clearing the backlog of underwritten deal volume, which is still pretty much on bank balance sheets in early 2023. And we expect that to happen via secondary trades. So, long winded way of saying it's really a priority to get any sustained momentum around the new calendar of 2023 deal flow by clearing the backlog.
CJ Doherty: Right. And I think further impacting loan activity. M and A looks set for a slow start this year, at least through the first half of the year. There's not a lot of market visibility around opportunistic deals and I guess not a lot of conviction among corporates or PE firms for deals of size. And then lenders, of course, want to do deals, but there is more scrutiny that comes with any prospective deal opportunity. And then I think for M and A to pick up, it looks like there needs to be more of a meeting of the mines. It will come back when buyers and sellers can come closer on valuations after the adjustment we saw last year. And at the same time, it only comes back when banks are able to confidently underwrite new financings. And the high yield bond market, which has shown some signs of recovery in early 2023, needs to be reliably accessible for issuers as well.
Maria Dikeos: Yeah, I think that's right. Also, I think we have to keep in mind that even if lenders get back to the business of making M and A commitments, those deal are not going to come out for about five or six months. From today. So deals being looked at right now are likely to be mid 2023 execution. So the question to ask is, what does that leave us with? And until M and A eventually picks up, the expectation is that leveraged loan deal flow in the early part of this year will be comprised mainly of add ons and refinancings.
CJ Doherty: Right. Though something else to keep in mind when it comes to refinancing is that many borrowers are holding on to their cheaper legacy pricings where they can, thus contributing to lower loan volumes. So for the time being, I think volumes are expected to remain quite low relative to historical levels.
Maria Dikeos: Absolutely agree. And of course, apart from the macroeconomic and technical factors we just touched on, there are additional market dynamics at play. The matter of credit fundamentals is pretty weighty, just as a point.
CJ Doherty: Yeah. And not all leveraged credits are created equal. We expect that there will be continued bifurcation between good credits and challenging credits in both the primary and secondary markets. Primary market loan yields climbed sharply last year, driven by higher base rates, wider OIDs, and richer spreads. However, in the latter part of 2022, attractive credits were pricing relatively tightly, flexing favorably to the borrower. But on the other hand, if companies need to refinance and find themselves at the lower end of the credit spectrum, they're going to have to pay up.
Maria Dikeos: Right. And it's sort of the same general theme we've talked about with regard to the secondary market. Higher quality companies or less cyclical industries have a pretty strong bid in the market, while more challenged credits are seeing their secondary prices languish in the market.
CJ Doherty: Okay, so moving on to credit quality, I think that'll be a big focus this year. Maria?
Maria Dikeos: Yeah. Given the change in market conditions in the last year, there is a focus on credit quality. Credit quality in the leveraged loan market was resilient for much of 2022, with default rates remaining low. But they are expected to climb in 2023.
CJ Doherty: Right. And to add to that, portfolio companies have mostly performed well to date, but macroeconomic challenges have signaled causes for concern. In the latter part of last year, revenues, we heard, were keeping up with inflation, depending on the industry, but margins were under pressure and declining.
Maria Dikeos: Yes, and there is a cohort of companies that are really over levered and their ratings are challenged. So there are already pockets of stress. Some companies will have problems with their interest coverage ratio as the year progresses, especially as higher interest rates start to take their toll you know, we do expect that there will be some rescue financings.
CJ Doherty: Right. And looking ahead on the CLO side, then, with regard to credit quality, triple C downgrades are a concern for CLO managers, and they're starting to pick up. And I think the expectation is that downgrades are probably going to be a greater driver of the market than default. Know, given the relative lack of near term maturities.
Maria Dikeos: Yes, and if we look a bit more closely at the demand side of the leverage loan market, we see that it has also posted mixed results over the last twelve months. I think the good news is that the US CLO new issue activity logged in 2022 totaled $129,000,000,000, which is the second highest total on record. And this came when CLO spreads were climbing and structures increasingly favored shorter terms.
CJ Doherty: Yeah, and to answer that, going forward, CLO issuance is expected to decline in 2023 with new issue forecasts are ranging at the moment from 90 billion to 100 or 125,000,000,000. So that general area. And so far in January, we've had like seven US. CLOs priced last week. There was five BSL, two middle market, and that brought year to date volume to 3.2 billion. Moreover, triple H spreads for the top or the tier one issuers have tightened from 220 basis points to around the 180 to 200 basis point area.
Maria Dikeos: Yes, and sticking for a moment with the demand side, May through December, 2022 retail loan funds saw huge outflows, totaling 36 billion. The good news is that there are some signs of optimism in early 2023. Last week we saw weekly fund flows turn positive for the first time since last June. And granted, it was only a small amount, totaling about $35 million, and it's only been one week, so it's definitely not a trend, but hopefully it's a start with more momentum around positive inflows to be seen.
CJ Doherty: Okay, so let's wrap up by touching on performance wise leverage loans. They actually managed to outperform nearly every other asset class last year, and they ended the year down less than 1%. That said, secondary loan market prices fell around seven points, but they moved somewhat higher in the fourth quarter, and they've started this year with gains of around one and a half points. So we're now back to September levels at around $0.93 on the dollar.
Maria Dikeos: Some investors think that the worst is not over, and secondary loan prices could again test their recent lows. And related to that forecasted, 2023 leveraged loan returns by bank research desks have varied widely from about 8% gain to an 11% loss. And that sort of illustrates the degree of uncertainty in the year ahead.
CJ Doherty: Right, so an interesting year ahead then. And on that note, we have to wrap up if that's all we have time for today. Thanks, Maria, and thank you for tuning in. I invite you to check out our leverage loan analysis at loanconnector.com. Follow us on Twitter at LPC loans. I'm CJ Doherty. Subscribe to the Lending Lowdown on your favorite podcast platform.
(Ad): When you contribute your fixed income deals to LSEG, they'll reach over half a million buy and sell side professionals around the world and be included in our industry leading league table rankings. To ensure we're capturing your entire deal flow, visit lseg.com/sign up or contact our team at contribute@lseg.com/fisignup. Make your deal count.
