Credit quality beginning to slip as European leveraged finance conditions boom
Leveraged finance borrowers are using favourable funding conditions to refinance their capital structures, extend their debt maturities and reduce their cost of capital, says Standard & Poor's Ratings Services.
According to “European Leveraged Issuance Is On The Up, But Recaps Are Pushing Credit Quality Lower”, issuance in the European leveraged finance market is booming for both high-yield bonds and loans, driven in part by a renaissance of the collateralised loan obligation (CLO) market.
So far in 2013, 20 European CLOs have been priced, bringing total CLO issuance for the year to just under EUR7.5bn. This is in sharp contrast to the past four years, when publicly placed rated CLO issuance in Europe was essentially on a hiatus, with little activity observed between 2009 and 2012.
However, liquid markets also bring risks and the potential for more aggressive financial policies from shareholders, many of whom in Europe are private equity sponsors. There is evidence of this in the steady increase in dividend recapitalisations (recaps) in the past year.
"We've not seen a dramatic increase in the number of downgrades as a result of these recap transactions since much of the issuance has come from companies that are performing well," says Standard & Poor's research analyst Taron Wade. "However, we have started to see credit quality slip for companies extracting cash in the form of dividend recaps this year, compared with 2012."
In 2012, companies in the 'B+' category or above still outnumbered those rated 'B' or lower (at 3:2). This year, that ratio has swapped, with slightly more than 50 per cent (10 companies) rated 'B' or lower in 2013. S&P says taking cash out of a business can limit its growth potential and heighten uncertainty with regard to the owners' future support for the firms. It says potential recovery prospects for debt investors post-default can be diminished by these shareholder distributions, depending on where investors sit in the capital structure and the way in which a dividend recap is structured.
Issuance of both leveraged loans and high-yield bonds has rocketed in 2013. To the end of the third quarter, European speculative-grade bond issuance had reached EUR54.8bn, surpassing the market's EUR44.4bn record for 2010, according to data from S&P Capital IQ. On the loan side, over the same period, issuance was back to its 2008 level.
The characteristics of the post-financial crisis leveraged finance market are beginning to emerge, according to the research. The most obvious of these characteristics is that the percentage by value of non-sponsored debt transactions has increased since the extremely active pre-crisis market of 2006-2007.
For bonds, S&P believes this shift has occurred for two reasons. First, there has been an increase in the number of fallen angels – that is, where it downgrades companies from 'BBB-' or higher to 'BB+' or lower. The second reason for the shift to non-sponsored transactions in Europe that S&P has observed is that companies are seeking alternative types of financing as the banks rein back on their lending, particularly in countries such as Italy and the UK companies are finding that it's possible to obtain funding at rating levels of 'BB+' or lower as investors continue to seek higher yields in a low interest rate environment.
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