Opening with a bang”: An update on the European leveraged finance markets
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Daniel Schlumberger: Hello and welcome to our podcast. I’m Daniel Rudnicki Schlumberger, I’m the head of Leveraged Finance for EMEA for J.P. Morgan. And I’m joined today by my partner, Ben Thompson, who heads Leveraged Finance Capital Markets.
Ben Thompson: Hello Daniel.
Daniel Schlumberger: I’d like to start with Natalie Netter, who is our head of Syndicate for Leveraged Finance in Europe. So, Natalie, you’re in the thick of it, right? You’re on our trading floor. You hear the flows, you hear what our investors are thinking. How is the mood? How are the secondary markets these days?
Natalie Netter: The markets are strong, but interestingly, the mood is slightly frustrated. So While the markets are in fantastic shape, if you look on the loan side, we actually just yesterday reached a new 52-week high in cash price of loans. And in fact, you need to go back nearly two years to get to these levels. High yield, we have come off a little bit year to date, but marginally only call it 20 basis points. And we're still 150 basis points inside where we were in mid-October. And the index is still sub-7%. So Relative to where we've been, it's still strong. That said, there's a little bit of frustration, particularly on the high yield side, where I think everyone would have happily shut their books at the end of November, high single-digit returns. But we saw 500 basis points of performance into the last six weeks of the year. And that's frustrated investors because it feels like it'll be a little bit harder this year to make returns work, given just how strong last year ended up in an asset class that tries to pitch itself as a bit less volatile and you know high single-digit returns is perfectly adequate. But where we sit right now from an overall tone, it's positive.
Daniel Schlumberger: And spreads are really low.
Natalie Netter: Yes, certainly. So on the high yield side, we're over 100 basis points inside the 20-year average. We have seen very tight on the spread side on high yield. And then in loans, we've seen a very strong repricing of CLO liabilities, which is allowing that market to buy loans at a tighter spread, versus what we've seen over the last several months, if not a year and a half.
Ben Thompson: If you start to pick that apart, and I agree completely that the conditions are strong right now. How much of this rally is down to the technical imbalance versus investors' and lenders' view of the fundamental outlook for the economy and for particular sectors?
Natalie Netter: I think my point around frustration is such that it is mostly technical. So it's not as though investors are thinking that there's a great opportunity set given where they see the macro, et cetera. What it is simply technical. So on the high yield side, you saw very low net supply last year, coupon clipping, some inflows, and that led for them to have a very high cash balance. And historically, if you sit on too much cash, it's very difficult to outperform the index. And on the loan side, again, very low net new supply. And we just talked about how CLO liabilities are coming in, a very active CLO pipeline leading to demand. We have seven CLOs in market already this year. Most of those deals when they come to market are about half ramped, which means they all have 200 million of buying capacity. And If you take that seven number, and you speak to our CLO team, they see that seven going to the mid-teens in the next month. And again, all of those vehicles will be looking to add at least 200 million of paper. So it's very technically driven, rather than perhaps a fundamental view that things should be going tighter.
Ben Thompson: And Daniel, since you're on the front end dealing with the clients, the issuers and and the borrowers, you know, that concern about some of the macro events that could happen and could affect the market and how fragile this rally may or may not be, given that to Nat's point, it's very technical. I mean how-how are the borrowers and issuers and the owners of companies, financial sponsors, corporates, how are they feeling about the outlook? And how do you feel about the outlook from here for the rest of the year economically?
Daniel Schlumberger: I think we're still in a reasonably uncertain situation. It certainly looks better than six months ago. Economists think there is a 50% chance of a soft landing, which means that there's a 50% chance of a recession, either late in '24 or early in '25. That cautious view is probably shared by a lot of the CEOs and CFOs I meet. I have the feeling that risk markets are not taking into account such a high risk of recession. Which in turn means if the data is coming out worse than planned, the market is going to correct.
Ben Thompson: Do you feel that's the same way on the buy side, Nat, with the investors and lenders that they're all sort of trading these conditions the same way and that introduces that risk that, to Daniel's point, if some of the data comes out the wrong way, suddenly there's a correction in secondary and primary demand?
Natalie Netter: Certainly. I was going to actually turn the question back to Daniel because one of the points we hear a lot from investors is, why are we not seeing more refinancing now given how strong the conditions are and the fact that they're almost a reluctant buyer. You know, that’s the tone, is reluctant buyers. I think on the market side, there isn't the ability to sit on cash forever, so it needs to be deployed. There's a confusion as to why it hasn't been busier in terms of what you just described, which is the CEOs, CFOs seeing all of this uncertainty. I guess to turn it back to you, why has it been so limited in terms of the actual out-of-the-box activity we're seeing on that front?
Daniel Schlumberger: It is getting busier.
Ben Thompson: Yeah it is. I'd agree with that. I think as we think back and we like to benchmark ourselves at the start of your conversations to where we were a year ago with some of the major factors that would affect company confidence to go out and do a transaction or sponsor confidence to buy a company. If you think about at the time a year ago, the direction of interest rate trajectory was clearly higher. Inflation was still not at all under control. Rates were going up. The forward curve was looking like rates were going to go up even further. That chance of recession that Daniel referred to, a 50%, at least from our economists, was a much higher percentage chance of a recession. So I think what we've got now and the difference to this year is the trajectory of rates, whether it's straight from the mouth of the central banks or the way the markets are trading on the forward curve. Trajectory of interest rates is definitely downward over the course of the year. We can argue and people will about the speed and the pace at which those rate cuts will come and how the market will trade those. But Also now we have this sense that consensus is building around. If it is a recession, it's going to be fairly mild and there's a good chance that we avoid recession, particularly in the U.S.. Those are two big psychological barriers I think to transactions getting done. We still have a residual issue in terms of the difference in opinion on multiples, buyers and sellers, and we've seen that certainly over the course of 2022 and 2023. I'll turn it to Daniel in a second for his views on the sponsor activity. This could be the year where we finally see people meeting in the middle. So bridging that gap on valuations now that there's a little more confidence amongst the buyers that the economy could be okay and rates could come down, and the seller is now seeing that we're just not going to go back quickly to where we were two or three years ago. And I don't know if you're getting that sense, Daniel, from the sponsor community in particular that there's more pressure to do transactions during 2024. It would be interesting to hear your views on that.
Daniel Schlumberger: I think we're going to see a lot more M&A-related transactions in 2024 after a pretty lackluster 2023. If you look at the two sources of primary transactions that leverage loan and high-yield market, you've got M&A-related transactions that should get gradually better, but it takes time for auctions to mature. Then there's the refinancing. We've already started seeing in the refinancing space a flurry of transactions hitting the market. I think we should talk about that for our audience because in the U.S., in New York, it has been a flood of new transactions.
Ben Thompson: Yes, no, I agree. I think what's changed very rapidly and, frankly, has surprised us and the lenders is the pace at which we've gotten into a repricing market. So the bulk of last year's volume in Europe, anyway, on the loan side over 70% and on the bond side over 50%. The volumes that we saw, gross volumes in the region last year, those were refinancing trades. The bulk of those on the loan side being just amends to extend transactions where you push out the tenor of your loan by two to three years, and on the high-yield side more pound for pound, euro for euro refinancings of existing bonds, whether by exchanges or ultimately through just cash in, cash out. So that was the bulk of the volume last year. What we didn't see until this year outside of a couple of exceptions in early Q4 last year, were repricings. Which are more of a loan flavour, but those where you've got a loan at E plus 550. You come back to the lenders and say, you know "Bad news today, that loan is now going to have a 450 margin, do you want to hold on to your position or not? That started as you say in size in the U.S. right out of the gates at the start of the year. Europe was a little slower to get started but we've had you know half a dozen of those transactions now launched just in the span of the last several days. We're trying to catch up to what's going on in North America. That I think has surprised us a little bit in terms of how quickly that's come and how aggressively that's come. But I do think for the course of the year now, we would expect to continue to see that base load of extension transactions, refinancing transactions, but now also this latest wrinkle of repricing transactions. Back to you, Nat, as we've got a couple in market and others away from us, what are you seeing and how are the lenders reacting to that new phenomenon?
Natalie Netter: Sure. I mean, Obviously, the lenders prefer a nice new money transaction with a nice juicy spread rather than having margin taken away from them. Although I'd say generally the response has been fairly mature in terms of the fact that a lot of these loans were put in place at a time when market conditions were a bit weaker and the reality is there might be a little bit of whinging around the edges. They want to hold on to the paper and while they in one breath say, "We really wish you guys weren't launching repricings." On the other breath they say, "Do you think there'll be any new money for me to add?" So It feels like the European market environment is very healthy for the names that do have that little bit of excess spread in them. Talking about the refinancing theme, I think the loan market's done a more proactive job than the bond market in terms of pushing maturities out, as you said, last year. We saw huge volumes there. I think it's the high yield market where we're seeing investors questioning why we haven't seen more of that call refinancing activity, which of course if you look at the increase in costs given the interest rate moves, it's obvious issuers would want to wait. But Daniel, are you seeing that mentality shift now that we're into '24 and then also just given the dramatic moves we've seen in terms of where issuers can access? Are we feeling more traction on that side now?
Daniel Schlumberger: Yes. I think we're going to have a very busy year in terms of refinancing in many different guises. From the most simple maturity extension, we've got a lot of debt maturing in the next three years, €280 billion in Europe of leveraged loan and high-yield bonds are maturing in 2024, 2025 and 2026. That's a lot. That's 40% more than on the 1st of January, 2023. Straight refinancing, we're going to see more complicated transactions, potentially dividend recapitalization, debt issuance, funding dividend recapitalization, distribution to shareholders, a fund-to-fund transfer or continuation vehicles. Potentially we're going to see transaction looking to lower the cost of debt, for example, by refinancing second lien into cheaper or lower spread first lien debt if leverage is modest enough. Or why not even refinance a direct lending loan into the syndicated loan market? All these transactions are being considered. We've got quite a pipeline ahead of us. Now, the real question as for a borrower or an issuer of debt is, should I go now or should I go later? Are we at the beginning of a continuous improvement in the cost of debt or are we just in a good window? I would be interested in both your views.
Natalie Netter: Well, one thing I would say on that front is, if you look at what the market's pricing and you talked about how robust the view of where rates cuts are going and how that could end up being a disappointment. If you just look at the Euro five-year swap rate-- So If you look at six-month, which is what it's off of, that's still close to 4%, and five-year swaps are 265. So they're pricing in 135 there. You can capture that when you go to market today if you're doing a five-year deal. So It does feel like right now you have very low spreads. Interest rates have come down. I know there's the expectation that they come down further. On the loan side, if you look at where we're pricing new transactions on a spread basis, it's very attractive, and OID has come down massively. And We're all learning in real time that, you know what, if things get even better with your loan, you can come back later and reprice it at par. Why not go today, especially when you look at where OID has gotten to? I don't know, Ben, if you agree or disagree with that.
Ben Thompson: Yes, no, I do. I think the trickier question because again, if you're doing a loan transaction today, you can capture the falling rate either by just waiting for your base rate to fall out from under you if the forward curve is correct, or to your point, you can do a derivative trade right now to capture that forward reduction that the curve is showing. To me, the bigger question is on this high-yield side, because if you look at that component, Daniel mentioned the 40% higher level, which gets you to 280 billion of refinancing required across Europe, across loans and bonds in the next three years forward from here. 175 of that plus or minus is bonds, and the other 100-odd is loans. A lot of that loan bit is about 60% of that 100 billion in loans is 2026 maturity. So the loan market per se doesn't really have an extension need. The high-yield side, on the other hand, that 175, that's a big number that's got to get taken care of. And to your point before, Nat, the bias on the part of the issuers in some cases is, well, I'm going to two-handle, three-handle a piece of paper now, and I'm going to come out now much better than I would have a couple of months ago, but maybe that doubles in terms of my cost-cost of financing. That's really a reason to stop and think and say, "Well, do I really want to go now." Particularly if base rates do come down and I could issue safely in 12 months and capture that lower base rate. But the risk you take to your point exactly is spreads are really tight levels now across the asset classes, and if those start to move wider just because more volume comes or because we do start to hit some of these economic issues.
Natalie Netter: The scenario where your-your rates go down the most is one where your spreads widen.
Ben Thompson: Correct.
Natalie Netter: It should be relatively offsetting from that perspective.
Daniel Schlumberger: Actually, our credit stretches are expecting by the end of the year high-yield spreads to increase more than the five-year bond would decrease.
Ben Thompson: Yeah. Absolutely. So our view is bankers being typically fairly cautious by their nature. I think your advice to clients is whether you're capturing the falling rates by issuing a loan. If you're wrong on spread to your point, Natt, then you can come back in 6 to 12 months and reprice tighter if that option exists. You can capture the falling rate curve by staying floating, or you lock in fixed now, and most of the deals that we were doing up to this point have been five non-call too in the high-yield format, so you're locked in for two years. Do you really think things are going to get so much better in the capital markets in the next two years that you're really going to look at yourself and regret locking in now versus taking the chance that whether it spreads going higher, as Daniel was saying, the economy getting worse or just a lot more issuance, which is by its very nature going to drive things wider? Question why you would hesitate to do that now. I think some of that hesitancy though, as we've talked about, is the composition of the high-yield bond market in Europe tends to skew much higher rated in terms of credit quality, and as a result, I think those types of issuers are more inclined to think no matter how bad the markets get, they'll have access, it just could be more or less expensive. That allows them, I think, to take a slightly more complacent view about waiting as long as possible on their existing tightly priced debt.
Natalie Netter: We have seen an increase in partial refinancings to your point around that gives you multiple entry points into the market. We're working on a number of those transactions where the issuer or borrower doesn't want to put all their eggs in this basket. That's, I think, another theme that we'll likely see given that the market's far more attractive than it was over the last 18 months, but rates, you're still looking at doubling, tripling your coupon on the high-yield side.
Ben Thompson: Yeah
Daniel Schlumberger: I guess the conclusion is don't be complacent. It's a great market. Let's enjoy it while it lasts. It is probably still a market of windows. So thank you very much. If you've got any question, comment, suggestion for the podcast, don't hesitate to give us feedback through your J.P. Morgan contacts.
Natalie Netter: Thanks, Daniel.
Ben Thompson: Thanks, Daniel.
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