The leveraged finance market has been beefed up in 2021 by a special performance enhancing substance: fallen angels. With those companies on track to push back up to investment grade, this year’s records may remain unsurpassed for years to come.
To any observer, the sub-investment grade debt markets are enjoying a bumper year. Both leveraged loans and high yield bonds are set to smash annual records of issuance, with bankers suggesting to GlobalCapital that the tail end of 2021 will be as busy as the rest. The two products have racked up around €100bn of issuance volumes each.
Market participants have many things to thank for these figures. The numbers have been propelled by a healthy appetite for funding from corporations, high levels of dry powder in private equity and a cash-rich environment on the buy-side. But an important — if often overlooked — aspect of the story is the part played by fallen angels.
As the coronavirus pandemic wreaked havoc on earnings, a raft of investment grade companies were rebranded as junk last year. Bonds totaling roughly $187bn have fallen below investment grade over the course of the last 18 months. This, in and of itself, made the leveraged finance universe much bigger. What's more, many of the companies suddenly finding themselves in the speculative grade category had to raise funding to tide them over during the pandemic, bolstering volumes.
Some of those deals, while technically classed as sub-investment grade on a strict reading of the ratings, may have been handled by bankers on investment grade desks, priced near to investment grade spreads, and held in funds with sufficiently loose investment grade mandates.
But amid the massive uncertainty surrounding the course of the pandemic and its impact on economies, many fallen angels would have been compelled to offer enough juice to entice high yield investors, especially since the European Central Bank in June 2020 declined to extend its purchase programme to those with no IG ratings left.
There are now more rising stars being made than fallen angels, though we are only at the beginning of the reversal. According to Bank of America research, up until the end of July just 13% of the recently demoted companies had returned to rising star status, including Fiat Chrysler, JDE Peet and Irish building materials firm Smufit Kappa Group.
But the direction is clear: many companies are due for an upgrade. S&P sees potential rising stars including KION, Volvo and the Weir Group. JP Morgan analysts point to Netflix and T-Mobile.
This poses a problem for anyone in the leveraged finance market who is interested in annual deal flow. For all of the funky addbacks and covenant disintegrations that investors can accept, if the number of companies promoted to investment grade continues to rise, the market will lose access to borrowers it was just getting acquainted with.
Borrowing costs can escalate dramatically between the lowest investment grade rating and the highest rung of junk. According to Moody’s, the difference in borrowing costs is as much as 129 basis points between the two. That means a rising star which raised debt capital while it was down has a big incentive to refinance the debt with IG pricing at the earliest possible moment. For high yield bonds, investors typically have two years before their notes can be called. For leveraged loans it is a mere six months.
If, as expected, there is a wave of rising stars to come, the leveraged finance market could turn out to be smaller than it appeared.