Breaking Down the Wall of Debt: The Leveraged Loan Market

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1 7/14/21 Breaking Down the Wall of Debt: The Leveraged Loan Market Meredith Coffey, EVP LSTA 1 Panel topics Brief review of where we have been Behind the rally (and retrenchment): The Virtuous and Vicious Cycles CLOs and the Refinancing Cliff: Progress and a few problems The Outlook 2 1

2 1/1/21 1/22/21 2/12/21 3/5/21 3/26/21 4/16/21 5/7/21 5/28/21 6/18/21 7/9/21 1/1/29 3/1/29 5/1/29 7/1/29 9/1/29 11/1/29 1/1/21 3/1/21 5/1/21 7/1/21 1/7/2 1/7/21 1/7/22 1/7/23 1/7/24 1/7/25 1/7/26 1/7/27 1/7/28 1/7/29 1/7/21 Bid (% of par) 7/14/21 4 key U.S. large corporate loan market segments Investment grade loan market Loans to companies rated >= BBB-/Baa3 AND with a relatively low LIBOR spread 27 lending: $658 billion 28 lending: $319 billion 29 lending: $229 billion LTM 1H1 lending: $279 billion Leveraged loan market Loans to companies rated < BBB-/Baa3 or unrated & with a high spread* Divided into bank and non-bank segments 27 lending : $689 billion 28 lending : $294 billion 29 lending: $239 billion LTM 1H1 lending: $34 billion Institutional loan market Leveraged loans with non-bank lenders (such as mutual funds, CLOs, insurance companies, hedge funds, etc) 27 lending: $426 billion 28 lending: $69.6 billion 29 lending: $56 billion LTM 1H1 lending: $126 billion Secondary loan market Market in which loans trade following the close of primary syndication Most U.S. loan trading involves leveraged loans 27 trading: $52 billion 28 trading: $51 billion 29 trading: $474 billion *Traditionally LIB+15, increased to LIB+35 in 1Q9 Source: Reuters LPC for primary lending; LSTA for secondary trading 3 Last 12 months have seen a considerable recovery And a retrenchment U.S. Index bid levels (2-6/1) 15 1 U.S. Index bid levels (29-6/1) U.S. Index bid levels (21td) Loan prices dropped more sharply than in the downturn 88 There were multiple drivers to the downturn 87 Loan prices rallied back very sharply in 29 Rally continued through April 21, but then fell victim to global jitters Source: S&P/LSTA Leveraged Loan Index 4 2

3 Default rate (%) 12/31/1998 4/3/1999 8/31/ /31/1999 4/3/2 8/31/2 12/31/2 4/3/21 8/31/21 12/31/21 4/3/22 8/31/22 12/31/22 4/3/23 8/31/23 12/31/23 4/3/24 8/31/24 12/31/24 4/3/25 8/31/25 12/31/25 4/3/26 8/31/26 12/31/26 4/3/27 8/31/27 12/31/27 4/3/28 8/31/28 12/31/28 4/3/29 8/31/29 12/31/29 4/3/21 7/14/21 After deteriorating sharply, U.S. fundamentals improve 12% S&P/LSTA Leveraged Loan Index default rate 1% 8% 6% 4% 2% % Loan default rate did hit record high Default rate already dropping Many companies exiting bankruptcy But the recovery is more about technicals than fundamentals Source: Standard and Poor s/lcd 5 The Virtuous (refinancing) Cycle 1. Record volume of outstanding institutional corporate loans 2. Nearly half are held in CLOs 3. CLO reinvestment periods will end 4. But loans must be repaid 5. The gap between borrowers refi needs and CLO refi ability is the refinancing cliff 6. Issuers and bankers focus on paying down the refinancing cliff, using HY bonds 7. Repayments go back into CLO wallets 8. CLO money needs to be reinvested now 9. CLOs buy loans in primary/secondary 1. With little supply, this creates excess demand 11. Loan terms become much easier 12. Markets cheer But what happens if the Virtuous Cycle Stops?

4 Outstandings ($Bils) 1997 Volume ($Bils.) Jul-8 2 Aug-8 21 Sep-8 22 Oct-8 23 Nov-8 24 Dec-8 25 Jan-9 26 Feb-9 27 Mar-9 28 Apr-9 29 May-9 YTD 5/31/21 Jun-9 Jul-9 Change in outstandings ($Bils.) Aug-9 Sep-9 Oct-9 Nov-9 Dec-9 Jan-1 Feb-1 Mar-1 Apr-1 May-1 Jun-1 7/14/21 U.S. HY bond issuance very strong through April 21, Declines significantly in May and June Monthly HY bond issuance HY bond issuance revives in 2H9, accelerates in1q1 Proceeds repay loans HY issuance drops sharply in May Source: Thomson Reuters LPC 7 U.S. HY bond outstandings climb, Loan outstandings shrink HY market outstandings Change in outstandings (29 vs. 28; 5/1 vs 29) High-Yield Second-Lien Institutional First-Lien Institutional Change (5/31/1 vs YE 29) Change (YE 29 vs. YE 28) First-Lien Institutional Second-Lien Institutional High-Yield -1 The market began to address loan maturities HY bonds repaid loans, and loans saw other partial/full paydowns Inst. loan outstandings declined more than $6 billion in 29, and another $25 billion through May 21 Source: S&P/LCD, Merrill Lynch 4

5 Mar Apr Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May June July Volume ($Bils.) 1/1/21 1/22/21 2/12/21 3/5/21 3/26/21 4/16/21 5/7/21 5/28/21 6/18/21 7/9/21 1/1/29 3/1/29 5/1/29 7/1/29 9/1/29 11/1/29 1/1/21 3/1/21 5/1/21 7/1/21 1/7/2 1/7/21 1/7/22 1/7/23 1/7/24 1/7/25 1/7/26 1/7/27 1/7/28 1/7/29 1/7/21 Bid (% of par) 7/14/21 Technicals (and fundamentals) lead to strong rally U.S. Index bid levels (2-6/1) U.S. Index bid levels (29-6/1) U.S. Index bid levels (21td) Loan prices dropped more sharply than in the downturn 88 There were multiple drivers to the downturn 87 Loan prices rallied back very sharply in 29 Rally continued through April 21, but then fell victim to global jitters Source: S&P/LSTA Leveraged Loan Index 9 U.S. Institutional loan calendar strengthens in 21 2 U.S. Institutional loan pipeline After a two-year hiatus, the U.S. institutional loan pipeline begins to fill And then, PIIGS II strikes Source: Thomson Reuters LPC 1 5

6 Aug-8 Sep-8 Oct-8 Nov-8 Dec-8 Jan-9 Feb-9 Mar-9 Apr-9 May-9 Jun-9 Jul-9 Aug-9 Sep-9 Oct-9 Nov-9 Dec-9 Jan-1 Feb-1 Mar-1 Apr-1 May-1 Jun-1 Volume ($Bils.) 1/4/21 1/12/21 1/2/21 1/28/21 2/4/21 2/12/21 2/22/21 3/1/21 3/9/21 3/17/21 3/25/21 4/5/21 4/13/21 4/21/21 4/29/21 5/7/21 5/17/21 5/25/21 6/2/21 6/1/21 6/18/21 6/28/21 7/6/21 1/4/21 1/12/21 1/2/21 1/28/21 2/4/21 2/12/21 2/22/21 3/1/21 3/9/21 3/17/21 3/25/21 4/5/21 4/13/21 4/21/21 4/29/21 5/7/21 5/17/21 5/25/21 6/2/21 6/1/21 6/18/21 6/28/21 7/6/21 Bid (% of par) Change in bid (pts) 7/14/21 U.S. loan and HY bond prices slide U.S. HY bond vs. inst. loan bids U.S. HY bond and inst. loan bids (Change from YE9) BAML US HY Price BAML US HY Price S&P/LSTA Index Price S&P/LSTA Index Price After strong run up, both U.S. loan and HY bids slump HY bond prices recovering, loan prices lagging Source: S&P/LSTA Leveraged Loan Index, Merrill Lynch 11 U.S. institutional loan and HY bond issuance slumps 4 U.S. HY bond vs. inst. loan issuance Inst loans HY bonds Issuance drops sharply in HY bond market following Euro-jitters U.S. institutional loan issuance drops, but market remains open at a price Source: Thomson Reuters LPC 12 6

7 1Q98 Mar-99 Sep-99 Mar- Sep- Mar-1 Sep-1 Mar-2 Sep-2 Mar-3 Sep-3 Mar-4 Sep-4 Mar-5 Sep-5 Mar-6 Sep-6 Mar-7 Sep-7 Mar-8 Sep-8 Mar-9 Sep-9 Mar-1 Oct-9 Nov-9 Dec-9 Jan-1 Feb-1 Mar-1 Apr-1 May-1 ME 6/3/1 Spread (bps) Spread (bps) Volume ($Bils.) Yield (%) 7/14/21 Reverse flex dominates 1Q1, upward flex returns in 2Q1 Flexed loan yields much higher 15 U.S. institutional flex activity Pre- and post-flex yields on loans that flexed in May Down Up 1Q8 2Q8 3Q8 4Q8 1Q9 2Q9 3Q9 4Q9 1Q1 2Q OID over 3 yrs Spread Floor Talk Print Source: Thomson Reuters LPC Source: S&P/LCD Following May pullback, U.S. institutional loans flex up (by considerable amount) to clear market 13 U.S. loan yields retrench in 1Q1, jump in May (B/B+ rated institutional loans) U.S. institutional loan spreads (with OID, LIBOR floor) Libor Floor Benefit Upfront fee over 3Y mat Straight Spread U.S. institutional loan spreads (with OID, LIBOR floor) Libor Floor Benefit Upfront fee over 3Y mat Straight Spread U.S. Institutional yields increase considerably in May, June 21 Source: Standard and Poor s/lcd 14 7

8 Volume($Bils) Volume($Bils) 7/14/21 CLOs and the refi cliff dynamic 15 U.S. Refinancing cliff revisited U.S. Refi cliff (April 29 vs. June 21) Change in refi cliff (April 29 vs. June 21) April 29 est refi needs June 21 est refi needs Refinancing cliff has shrunk Maturities (through amend & extends) have been pushed off materially Source: S&P/LSTA Leveraged Loan Index 16 8

9 Volume of loans ($Bils.) Volume of loans ($Bils.) 7/14/21 Our cliff analysis in July 29 And what the cliff looks like now 25 Refi need analysis (July 29) 25 Est optimist cliff in 29 vs. cliff in 21 2 Original cliff Less defaulted loans 2 May 29 est cliff (less defaulted loans, HY bond repmts and A&Es) 15 1 Less defaulted loans and HY repmts 15 1 June 21 est refi needs Original cliff has $576B of loans (red) If half B-, all CCC s and D s default out, cliff shrinks to $421B (blue) If loans default out and HY paydowns occur, cliff shrinks to $344B (green) If loans default out, HY paydowns occur and loan maturities are extended, cliff remains at $344B, but flattened (purple) ACTUAL RESULT: Cliff still larger, but shape reflects estimates Source: S&P/LCD, LSTA 17 How the refi cliff has changed By ratings 25 Expected refinancing schedule (July 29) 25 Expected refinancing schedule (July 21) 2 15 D CCC+ to CC B- B+/B >= BB- NR 2 15 D CCC+ - CC B- B+/B 1 1 >= BB- NR Charts show refi cliff by rating (assuming loans must refi one year prior to contractual maturity) In 29, the refi cliff was fairly front loaded In 21, refi cliff is smaller and more back-ended Source: S&P/LCD, LSTA 18 9

10 H1 Inst issuance ($Bils.) CLO issuance ($Bils.) Market share (%) Share of deals (%) 7/14/21 Negative bias: Better quality companies are doing A&Es 35% Distribution of ratings: A2E companies vs. index 3% 25% Index (end June) A2Es (end April) 2% 15% 1% 5% % >= BB- B+ B B- <=CCC+ NR It is the better rated companies that have been doing most of the Amends-to-Extends B+ and better cos account for 53% of A2Es, and just 3% of index This could leave weaker companies facing an earlier refinancing Source: S&P/LCD, LSTA 19 CLO issuance buoys institutional loan growth Both markets stop in 28 Institutional loan, CLO issuance Investor market share % 4 CLO issuance 8 7% 35 3 Total institutional loan iss. (incl refis, repricings) 7 6 6% 5% % 3% 2% Bank CLO Fin co Hedge, Dist., HY fund Ins co % % Institutional market growth enabled by CLO growth Severe dislocation in CLOs and institutional loan market in 28 CLO issuance stops, but existing CLOs still recycle paydowns into loans Source: Thomson Reuters LPC, S&P/LCD 2 1

11 Volume ($Bils.) Volume($Bils) Volume ($Bils.) /14/21 As we discussed last year: CLO reinvestment period will end, reducing CLO demand CLO issuance vs. CLOs going static Theoretical CLO reinvestment capacity Max reinvestible $ Cumulative decrease in demand as reinvestment period ends Cumulative CLO outstandings 5-3 CLO issuance peaked in 27 (Outstandings in red) CLO reinvestment periods range 5-7 years (Blue reflects frozen amt of CLOs as reinvestment ends) As reinvestment periods end, CLOs will no longer be able to buy new loans In turn, re-investible dollars will decline Blue line reflects MAXIMUM reinvestible CLO dollars eg, if all loans in CLOs are repaid In reality, reinvestible dollars will be much lower Source: LSTA,S&P/LCD, Intex, Wachovia 21 The Cliff Refined: Refinancing needs of loans in CLOs Vs estimated CLO refinancing ability 12 Maturity profile of CLO loans vs. CLO refi capacity 1 8 Est performing loans held in CLOs 6 CLO total refi capability (all reinvested) Assumes roughly 52% of performing loans are in CLOs based on size of CLO market and default rates Refinancing gap between loans held by CLOs and CLO refi capacity is smaller There remains a nearly $1B gap in 212 Manageability may revolve around health of HY bond market, revival of CLOs and ability to attract new investors Source: S&P/LSTA Leveraged Loan Index, LSTA, Wells Fargo, Intex 22 11

12 Share of liabilities tranches originally rated AAA 9/1/8 11/1/8 1/1/9 3/1/9 5/1/9 7/1/9 9/1/9 11/1/9 1/1/1 3/1/1 5/1/1 1/1/8 11/12/8 12/16/8 1/26/9 2/24/9 4/6/9 6/4/9 7/31/9 1/1/9 11/19/9 12/31/9 2/5/1 3/9/1 4/1/1 5/4/1 Bid (% of par) Share of CLOs (%) 7/14/21 CLO performance: U.S. CLOs heal as they delever and loan market recovers Avg. bid of CCC loans Share of U.S. CLOs in sub. OC violation 9 6% 8 5% 7 4% 6 3% 5 2% 4 1% 3 % Price levels on CCC loans fell sharply in the downturn In combination with increasing CCC/D share, this pressured OC ratios As loan prices recovered, more CLOs moved out of OC violation Source: Standard & Poor s LCD, S&P/LSTA Leveraged Loan Index, Wells Fargo, Intex CLO performance: U.S. CLO AAA notes remain relatively well rated 6% CDO AAA rating transition 5% 4% CLO AAA TRUP CDO AAA ABS CDO AAA 3% 2% 1% % AAA AA A BBB BB B CCC CC C WR NR Nearly all securitized products have seen their AAA tranches downgraded However, as of November 29, 95% of CLO liabilities originally rated AAA remain rated A or better More than 9% of SF CDO AAAs are rated below IG True CF CLOs have not suffered uncured EODs Source: Wells Fargo, Moody s Investor Service 24 12

CLO outstandings ($Bils) Hypothetical new CLO outstandings

) 7/14/21 Some CLOs put on review for upgrade 25 CLOs likely

outstandings and estimated equity component 25 With less

5x leverage 15 1 5 Same amt of Half the equity Quarter the

Assuming 1x leverage, this suggests approximately $25B of

13 CLO outstandings ($Bils) Hypothetical new CLO outstandings ($bils.) 7/14/21 Some CLOs put on review for upgrade 25 CLOs likely to revive; Unlikely to be the force they once were CLO outstandings and estimated equity component 25 With less leverage, total size of CLOs shrinks 2 Debt Equity *Assumes 5x leverage Same amt of Half the equity Quarter the equity equity There is roughly $25B of outstanding CLOs Assuming 1x leverage, this suggests approximately $25B of equity With lower leverage, overall size of CLO market would shrink even assuming robust equity demand Source: LSTA, Wachovia, Intex 26 13

14 7/14/21 Regulatory (and other) challenges Investors are (relatively) happy with CLOs and new issue is beginning to emerge; however, regulations pose a threat to CLO revival Regulatory reform legislation Actively managed third party CLOs are very different from the static ABS deals that were targeted in the risk retention plank; however, they are likely to be captured Either the securitizer or the originator will need to hold up to 5% of the credit risk Securitizer may be the structurer (who is just an agent of the manager and may exit the business rather than hold 5%) Some CLO managers can find a way to hold 5% of the equity slice, but many cannot; almost none can hold a vertical pro rata slice Originator who makes a loan and sells it directly or indirectly to an ABS (CLO) may have to retain 5% of the loan. This may force changes to trading docs to prohibit sales to CLOs; it may disrupt the entire trading market. FATCA Requires CLOs to provide tax identification on all investors beginning 212 or withhold 3% of passthru income. CLOs often don t know their investors, and indentures may prohibit withholding CLOs may not be able to participate in new loans or A&E deals after March 212 Reg AB More disclosure requirements, but may be workable 27 14

CLOs Today. Moderator: Meredith Coffey, LSTA

CLOs Today. Moderator: Meredith Coffey, LSTA CLOs Today Moderator: Meredith Coffey, LSTA Panelists: Wynne Comer, Bank of America Merrill Lynch Mary Katherine DuBose, Wells Fargo Tricia Hazelwood, Mitsubishi UFJ Jane Lee, Blackstone GSO Josh Terry,