Political risk, inflation and uncertain monetary backdrop… and still leverage loan issuance reached its highest level since the financial crisis at the start of 2017. Can nothing upset debt markets? Given the continuing high level of support from monetary policy and a better than expected economic outlook, the likelihood is that conditions will remain broadly creditor friendly in 2017 – so long as major market risks don’t crystallise. But, that’s not to say that conditions aren’t changing – even within some of the more benign scenarios. As with so much else in 2017, the times are finally a-changing.
A friendly start to 2017
EY’s latest Credit Market Report details the continuing resilience of credit markets across investment grade, leverage loans, alternative finance, asset based lending….There was an obvious pause around the UK’s EU Referendum, but most markets played catch-up thereafter. Even, European leverage loan issuance in 2016 was in-line with 2015 volumes. And – as per the intro above – 2017 has started with Moody’s recently reporting that EMEA leveraged finance markets had posted the highest issuance volumes since the financial crisis.
So – as with other markets of the markets – growth hopes and liquidity continue to triumph over risks and fears. In debt markets specifically, appetite is also being driven by increasing competition as banks redeploy capital after years of deleveraging; alternative lenders raise record amounts of capital and increase innovation; and the European CLO (Collateralized Loan Obligation) market continues its re-emergence. Companies are capitalising on high levels of competition in what is still quite a sparse time in terms of issuance – despite the increase in M&A activity. Most activity consisted of refinancing in 2016 – and much of that has now been done out beyond 2018. This competition is containing upward pressure on credit spreads.
And thus, it is still a borrower friendly environment in early 2017, with lower pricing, higher leverage appetite and looser documentation.
A word on alt-lending
In 2016, we saw alternative lenders extended the range of transaction sizes that they can invest in, mainly through either partnering with banks or increasing their appetite. Smaller funds have focused on identifying niche areas and financing small mid-market transactions, where there are more off-market opportunities and less competition. Their increasing appetite to finance transactions with higher credit risk characteristics, through junior and/or equity-like financing- and their flexibility in structure, has also certainly applied pressure to banks’ market position.
Reports suggest that the funds raised by European private debt providers for 2017 are substantial, giving them even more firepower to compete with the syndicated and high-yield markets. Globally, data from Prequin, shows total funds raised are down on 2015, but that was a record breaking year. Of the 10 largest global funds that closed in Q4, three are targeting European investments.
But, this isn’t exactly more of the same…
If the fundamentals of the market remain the same, demand should continue to exceed supply in most markets creating competition and options at investment grade in particular in 2017. But, change is coming – even if major risks don’t manifest into game changing events. We are in the midst of significant political and economic change after an extended period of relative stasis. Even under the most benign scenarios, debt markets dynamics change as growth and reflation reshape investment profiles and central banks’ monetary policies, which have provided huge and liquid market cushion since the financial crisis.
After last week’s strong US jobs report, markets are now pricing a 90% chance of a US interest rate rise at the next FOMC meeting later this month – and up to two further increases in 2017. Inflation topping 2% in the Eurozone raises interesting questions for the ECB. They seem unlikely to raise rates, but they’re no longer on a loosening path and the tapering could have some interesting effects on a market where yields have converged under QE. We expect to see greater divergence as investors start to take a more detailed look at country and sector risk.
This scenario doesn’t create an adverse environment, but it could be a much more differentiated one. Reflation hasn’t yet inspired a great rotation from bonds into equities, but for how long will investors continue to support both markets if liquidity tightens? Lenders should become more selective if spreads rise. And if markets remain buoyant, we can also expect to see more regulatory interest. The ECB already look set to implement guidelines in line with US Leverage Lending Guidance.
And those risks…
And, we also need to acknowledge the adverse scenarios, where markets could tighten more dramatically – and even stall. The path we tread in 2017 is highly dependent on how investors react to threats – without as much central bank cushioning – and any manifestation of an increasingly long list of risks .
Arguably the biggest issue in debt markets – the chance that GREXIT and BREXIT will be superseded by FREXIT – isn’t one that topped many lists at the start of 2017. The probability that French presidential candidate Marine Le Pen will ultimately win and fulfil her manifesto promise to take France out of the EU and the Euro seems to be diminishing – at least according to polls and French-German sovereign bond spreads. Although, polls and markets haven’t exactly proved to be fool proof election indicator! This diminished faith in itself could inspire greater volatility – and pauses – around the 23rd April first round and then the 7th May run off, if Ms Le Pen goes through.
From energy to retail?
And if we go back to the more benign scenarios, ratings agencies show defaults falling in 2017, primarily as result of a higher oil price and expectations of better growth in the US and Europe (ex-UK). The energy sector was the main driver of defaults in 2016, but these are forecast to slow in 2017. But there is one sector to watch, one where economic fundamentals are turning against companies perhaps more than anywhere else – retail. Junk retail is the only part of the US high-yield market to suffer losses this year, according to data from Bloomberg Barclays Indices. European markets too have seen a number of high profile retailers enter debt restructuring. This looks like an interesting place to watch – as do other related areas, such as retail landlords and travel & leisure sector – as consumers come under greater pressure and spending dynamics change.
The EY ITEM Club releases its latest special report on UK consumer spending on Monday, 20 March.
You can read more of our thoughts on global capital markets in our latest issue of Credit Markets 2016-17