High-yield bonds in, leveraged loans out

The high-yield bond market is becoming a favorite of companies that once raised cash using leveraged loans, luring borrowers with lower costs and a wealth of investor demand.

US firms have sold $55 billion of secured notes in the junk-bond market so far in 2023, marking a 17% year-over-year increase, according to CreditSights data. It’s the biggest issuance jump in more than a decade — and an indication that companies are replacing floating-rate debt in the wake of the Federal Reserve’s most-aggressive monetary tightening cycle in decades.

“It’s a good way to balance each of these markets off each other, and honestly, a better cost of capital,” said John Cokinos, global head of leveraged finance at RBC Capital Markets. “You can hedge naturally by just having fixed-rate debt.” 

US policymakers last week raised their benchmark rates for the 11th time since March 2022, with Fed Chair Jerome Powell leaving open the possibility of further hikes to quash inflation. The prospect of higher-for-longer interest rates is likely to propel secured, fixed-rate bonds even further in popularity over the next six to 12 months, said Cokinos. 

For many companies, the math is simple: The average yield for junk bonds is about 8.5%, while it’s roughly 9.8% for loans.

Investors also see a risk in floating rates, if, for example, yields start to float lower. As a result, the loan market has suffered massive outflows from retail funds this year, even despite a recent comeback in demand and a rally in secondary loan prices.

Many of the biggest buyers of leveraged loans — those who bundle them into collateralized loan obligations — are still under increasing pressure to cut back on their purchases as they run out of time to reinvest their money.

“As buying capacity shrinks, that’s making the high-yield market an attractive place to issue,” said Lauren Basmadjian, co-head of liquid credit and head of US loans and structured credit at Carlyle Group. 

So far this year, $18.5 billion of bonds have been issued to reduce loans, up from just around $14 billion in all of 2022, according to data from JPMorgan Chase & Co. Beauty company Coty Inc. offers a recent example, pricing $750 million of secured notes to repay a portion of outstanding loans.

CHANGING DYNAMICS

The fallout from higher interest rates is rippling into other types of deals, from corporate loan refinancing to leveraged buyouts. 

Many of the year’s major leveraged buyout transactions have come with a bond tranche, including Blackstone Inc.’s buyouts of of Emerson Electric Co.’s climate technology business and software firm Cvent Holding Corp. Banks also used a mix of junk bonds and loans to support Apollo Global Management Inc.’s acquisitions of aluminum products maker Arconic Corp. and chemical company Univar Solutions Inc.

Leveraged buyouts have historically relied on both markets, favoring loans when possible, where borrowers are free to refinance or pay off the debt whenever they like. Bonds, meanwhile, often have clauses that protect lenders’ yields for a period of time.

“Historically, to the extent that the loan market was open, it was preferable for sponsors to finance their LBOs with loan-heavier structures,” said Valerie Kritsberg, head of Blackstone Credit’s capital markets and trading. “Almost everything right now is being underwritten with loan and bond flex to give the banks and the sponsors maximum flexibility between the two markets, given the uncertainty on execution created by market volatility.”

The year’s sparse issuance of new loans, however, has helped spur a small resurgence in demand from investors. Some recent leveraged buyout deals — such as those for Univar and Arconic — were even able to shrink the bond portions of their transactions in favor of larger loan tranches. 

Still, it’s unclear how long a comeback in demand can last as a data-dependent Fed continues to disavow inflation. The resurgence has also fallen short of reaching short-term loans. 

Bank of America Corp. strategists say there’s a $50 billion investment gap in the loan market as existing debt comes due and CLOs can’t reinvest in companies’ obligations. Now, the odds are rising that many short-term loans will continue to be held by lenders who can’t extend them, said Scott Macklin, head of leveraged loan strategy at AllianceBernstein. 

“The ultimate question is at what point do the secured bond markets become too saturated with loan replacement issuance,” he said.