Numerous Federal Reserve actions, including QE3 and Operation
Twist, have flooded the markets with liquidity, depressed interest rates and
flattened the yield curve. Domestic banks, unlike those in Europe, are well
capitalized and have the capacity and willingness to lend. Investors searching
for yield, but unwilling to assume equity tail risk have a large appetite for
debt securities. Investment grade securities have priced so aggressively that
more investors are marching up the risk curve.
The demand for
noninvestment grade firms and higher 'risk structured' credit product is
growing at a rapid rate. It is starting to feel like the pre-crisis 2005-2007
period. It is a good time to be an issuer/borrower. Hence we are seeing the
return of bull/spring market debt capacity enhancing products as outlined in my
prior post Back
in Fashion Again. These include PIK, second lien loans and covenant lite.
High yield
bond issuance (non-investment grade issuers with ratings below
BBB-) is up 35%+ over 2011.The inflow of new investor funds into high yield
bond funds is driving the demand for these instruments. Equally important is
the growth in leveraged (non-investment) borrowers. Volumes are up 25%
over the prior. They have reached their highest level since the crisis and the
third highest level in history.
The majority of leveraged
loans are structured as term loan “B” and sold to nonbank institutional
investors. These investors are attracted to the asset because of the high
yields LIBOR + 450-525 basis points with LIBOR floors of 125 basis point for the
Bs and LIBOR + 900 on second lien loans. Additionally, they like senior secured
floating rate features.
The return of
collateralized loan obligations (CLO) is another development increasing the
demand for leveraged loans. CLO are securitization vehicles that purchase and
pool leveraged loans. They then tranche instruments used to fund their
investments with lower rated tranches serving as enhancement for the higher
rated tranches. CLO volume has increased to over $50B this year compared to
just $12B in 2011. This is yet another sign of increased investor risk appetite.
M&A volume is highly
dependent on credit. If credit is available bidders will use. This is reflected
in rising M&A volumes, elevated purchase pricing and larger transactions. A
current example is Freeport-McMoRan’s combined $10B acquisitions of two oil and
gas firms at significant premiums. Although remaining marginally investment grade
at BBB/negative outlook and a stock market beta of 2.3, JPMorgan felt
comfortable enough to act as sole initial underwriter for $9.5B of loans.
It is important to remember
that these market windows of financing opportunity can close
abruptly-especially for lower rated firms and higher risk structures.
Significant macro headwinds including the fiscal cliff, slow growth and Europe
still remain. Therefore, I strongly suggest the following:
- Locking in your financing with as few lender outs as possible. Borrower bargaining power has increased.
- Be prepared to assume pricing and structure flex clauses in commitment letters. These allow lenders to increase pricing and reallocate portions of the loan if market condition change to clear the market.
- Try to build financial flexibility into your merger agreements.
You can only take what the
market offers. Currently the credit markets are in a holiday mood and offering
a lot. So take it while you can, but be prepared should conditions change.
J
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