The US leveraged finance market is an ideal combination of high-yield bonds and leveraged loans. The leveraged lending market has grown multiple times since the financial crisis, as has the rate of high-yield bond issuance. These growth levels have efficiently surpassed regular loan and corporate bond issuance. The US’s low-interest-rate environment has prompted investors to follow yield, helping the country’s indebted companies obtain further leverage. Why are leveraged loans so important to the US economy?
What are leveraged loans?
Lenders extend leveraged loans to businesses that already have long- or short-term debt or poor credit ratings. These loans are often riskier than traditional loans, and lenders, therefore, demand a higher rate of interest on them. Most US businesses generally use leveraged loans for the following purposes:
M&A deals: These are leveraged buyouts in which leveraged loans form some part of the funds.
Balance sheet re-capitalisation: A company may use a leveraged loan to change its balance sheet while repurchasing stock.
Debt refinancing: A company may use this loan type to refinance its existing debt.
General corporate functions: A company may use these loans to support its corporate operations or finance assets such as property, equipment, machinery or production plant.
Value to borrowers
US companies that need cash for investment, innovation or growth often consider the different financing options available to them, including debt and equity. Leveraged lending is a critical medium of external financing. Leveraged loans are unique because they provide value to the borrowers that no other funding option offers.
Faster resolution and a higher survival rate
Many regulators want to reduce the funding available for leveraged buyouts (LBOs) – instances where an investor acquires another company using loans or bonds. Such investors use the acquired company’s assets as collateral for such loans, along with their own assets. Private equity ownership, or an LBO, often leads to increased value and operating performance for the target firm. This growth is much higher than that of competitors that do not have the support of private equity groups. In addition, when a private equity-backed firm faces a financial crunch, it resolves the distress faster and with a higher survival rate than those not backed by private equity.
Lower likelihood of default
The probability of default by many US borrowers has decreased significantly in recent years. In October 2021, the decline rate peaked at 4.5%. However, by end-2021, regulators assessed it at 1.5%, far lower than in 2020. The highest default rate is expected from sectors such as energy, entertainment, leisure and retail.
The pandemic’s impact on the leveraged lending market
The pandemic had minimal impact on the leveraged lending market. Although lending activity declined significantly in 2020, it returned to pre-pandemic levels in 2021. In fact, leveraged loans reached a record high by end-1Q FY21 (ended xx xx 2020). The Coronavirus Aid, Relief and Economic Security (CARES) Act signed in March 2020 drove this rapid recovery in the US. It protected businesses from the effects of the pandemic. Simultaneously, businesses managed to maintain liquidity by taking on debt.
With the vaccine rollouts, the economy improved and raised hopes for a recovery. States started to open up and released pent-up consumer demand. Sales reached levels usually seen during the Christmas season. With the market turning optimistic, lenders were willing to take risks. Financing assigned for buyout activity and M&A also started increasing, bracing the market for growth. The lowered interest rates encouraged businesses to revise and refinance their debts and earn benefits.
The leveraged lending market is a small but significant part of the US financial system. The mortgage market has around USD10tn in outstanding mortgage loans and USD42tn in fixed income markets, according to the Federal Reserve and the Securities Industry and Financial Markets Association (SIFMA). The Loan Syndications and Trading Association (LSTA) identifies USD1.7tn in outstanding leveraged loans.
Although the leveraged finance market continues to grow, it is still smaller than fixed income securities. Corporate and investment banks and commercial and regional banks in the US must consider outsourcing their leverage financing operations to experts who can streamline their processes related to aspects such as underwriting, credit monitoring, KYC and compliance.