US Leveraged Loan Outlook: Headwinds may ease in second half of 2023

It was a tumultuous period for markets in 2022 as a variety of factors weighed on investors. In leveraged loans, risk aversion led to a secondary market sell-off and strangled the new-issue market, stifling refinancing opportunities and stranding committed LBO financing that arranging banks struggled to get off their books.

Total new-issue volume in the broadly syndicated loan market tumbled 63% to a 12-year low of $225.1 billion, as deal flow dried up on all fronts amid market volatility. Demand softened over the course of the year, as CLO origination was slower in the second half and cash outflows from retail funds accelerated.

As the books close on 2022 market prognosticators have weighed in on what the new year will bring with projections varied and darkened by macro-economic uncertainty and threat of recession. There are expectations that deal flow will remain light early in 2023, with activity gaining traction in the second half as market conditions normalize. Views differ as to how much issuance will accumulate by year-end, but there seems to be consensus that it will certainly be below trend.

By year-end, JP Morgan is projecting gross loan supply of $300 billion and $175 billion net, excluding refinancing and repricing. By the bank’s estimation that translates into increases of 30% and 15%, respectively, supported by “a clearer backdrop for growth and inflation,” a slower pace of Fed tightening, and less volatility. Analysts at Morgan Stanley put issuance up around 17% at $275 billion for 2023, albeit after a slow start to the year. Likewise, Barclays sees an increase in loan volume to the tune of $240 billion to $280 billion with lighter flow in the first half of the year and more normalized conditions in the second half.

Refinancing activity hit a seven-year low of $58.3 billion in 2022 amid the rising interest rate environment and downdraft in the secondary market, according to LCD. Higher refinancing in prior years — 2021 featured a whopping $178.5 billion — helped push out maturities, but the amount of institutional loans that are coming due in the next three years is more than at any other year-end period on record. Loans due to mature in 2023 are minimal at around $10 billion, but within three years the amount coming due in the institutional loan market balloons to $298 billion (as of Dec. 9).

Analysts agree that may translate into higher refinancing volume in 2023 compared to the past year as issuers address looming maturities, with Libor cessation in June 2023 potentially also playing a role. JP Morgan says it expects “less rate volatility and the need to address the transition to Sofr will lead to higher refinancing activity in 2023, although somewhat capped with yields at 12-year highs.” The bank is forecasting a loan index spread of 600 bps at year-end 2023, slightly wider than November 2022, and yield to maturity of 9.50%.

Not all see a bounce in overall new-issue volume. Wells Fargo is forecasting a 10% pullback of institutional loan supply, to $200 billion, due to “fewer LBO deals, less favorable technicals and stricter new issue terms.”

BofA Securities expects new money supply to decline by around 15% next year to $175 billion behind softer LBO and M&A volumes while an increase in refinancing from a multi-year low will be driven by borrowers forced into action against the maturity wall. “As challenged as this year has been for supply, we think next year will be even tougher,” a Nov. 20 BofA Global Research report states, “On the issuer front, the rising cost of debt is likely to put a lid on refinancings and buyouts, while high volatility combined with deteriorating fundamentals is going to reduce companies' urge to merge.”

To be sure, it was a challenging environment to syndicate loan financing supporting LBOs in 2022. According to LCD, full-year LBO loan volume slumped to $73.2 billion, which is the second lowest annual total over the past five years trailing only pandemic-stricken 2020 ($66.7 billion). Most of that supply was packed into a robust start to the year; 56% of the total was issued in the first quarter and 42% in January alone. Despite depressed figures M&A and LBO supply still accounted for 63% of total issuance in 2022 as opportunistic volume foundered.

LBO issuance is expected to remain light early in 2023 “given the lack of pipeline and bank commitments,” a Barclays research note says. As banks worked to move commitments made before the market downturn off their books over the course of 2022, there were few new deals being added to the queue. That said, private equity firms are still sitting on heaps of capital, with dry powder totaling roughly $788 billion as of Sept. 30, according to PitchBook, although that’s off the peak of $884 billion in 2021.

Moreover, private credit increasingly stepped in during the market disruption of 2022 to support large LBO deals, right into year-end with take privates of Maxar Technologies and Coupa Software serving as examples in December.

However, starting around mid-year, increased risk aversion was apparent even from private credit providers. Loan terms tightened and pricing increased, better reflecting pricing on loans in the syndicated market. Private credit providers reduced the sizes of loans they were willing to hold, resulting in larger lender groups involved in any given financing package.

Moody’s cautions that such appetite for large deals may wane away from the largest US direct lenders due to increasing credit risks but that private lenders will remain competitive. “This may be particularly relevant for lower-rated, single-B companies that may be struggling to access the leveraged loan market at an acceptable cost,” the agency says.

As for technicals, measurable demand has fallen steadily since 4Q21 as retail funds swung into the red in the second quarter of 2022 after five straight quarters of inflows. Net outflows for the year totaled roughly $5.7 billion as of Dec. 14, according to data from Morningstar. CLO issuance, the largest source of demand for leveraged loans, was slower in the second half. The full-year total remained elevated by historical comparison at $127.3 billion, although well off the record $187.1 billion in 2021. Looking ahead, new issuance forecasts for CLOs range from $75 billion to $125 billion for next year from credit-market research analysts at major banks.

This article originally appeared on PitchBook News