DIRECT lenders and other debt providers could face their first major test if the market enters a downturn this year, new research has claimed.
In its annual leveraged loan report, law firm White & Case predicted that rising default rates could be enough to destabilise the direct lending sector. However, by the end of 2018, confidence in the fundamentals of the debt markets were strong, despite some volatility.
“The broadening of the leveraged finance market to include asset managers and other debt providers has been a notable development in the post-crisis world,” wrote the report’s authors Colin Chang and Jeremy Duffy. “They have stepped into the breach at times when banks have been in retreat, succeeded in gathering assets and become a key part of the lending ecosystem – but that is only half the battle.
“As a relatively new phenomenon, certainly at such scale, direct lenders and relevant debt providers have not been tested in a true market downturn. That test may emerge in 2019.
“Should the market hiccup or hit a severe correction, many investors in these funds may find their holdings with lower recoveries than other leveraged finance sectors.”
Across Europe, leveraged loan issuance was down by 28 per cent year-on-year to €202.5bn (£177.5bn) in 2018, although these issuances were still higher than they were between 2014 and 2016. High yield bond issuance was down by 37 per cent year-on-year, but the average yield increased from 4.6 per cent in 2017 to 5.4 per cent in 2018.
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Overall, leveraged loans remained more popular in Europe than high yield bonds last year, and Chang and Duffy speculated that demand from investors will likely sustain issuance for the foreseeable future. However, if interest rates stabilise, demand for bonds may increase.
Chang and Duffy added that if economic conditions worsen or interest rates rise further, default rates could spike among direct lenders, and a rise in default rates “has the potential to destabilise the market.”
“It may take just a couple of distressed situations in which a lender loses its investment to shake investor confidence in the burgeoning new market,” they said. “This could have a knock-on effect for those accepting the looser terms in the term loan B market.
“As investors have been chasing yield for the past decade, an unexpected downturn in the leveraged finance market could ricochet into other areas and compound any slowdowns.
“With so many factors in play, market participants will be reluctant to make any hard and fast predictions for 2019. However, if history is any guide, the market is likely to continue to evolve to meet the needs of issuers and borrowers and, macroeconomic shocks aside, will continue to offer a wide range of options for all participants.”