Yahoo Finance

Winds of change are blowing through the leveraged finance market.

The turmoil sweeping markets is squeezing corporate borrowers that took on high levels of floating-rate debt in recent years. As rates rise, they will face higher interest expense and pressure on cash flows, a sharp reversal after years of inexpensive borrowing.

While companies had been enjoying the fruits of higher valuations and relatively easy lending terms, the pendulum is swinging and debt investors are turning cautious about borrowers' ability to pay off loans in the face of souring economic conditions. 

The shift has resulted in a slowdown in issuance of new loans in the private debt market, along with stricter covenants and higher credit costs, several investors said.

Even as lenders face more uncertainty, some are looking to capitalize on the new situation, which is likely to lead to more deals that offer higher spreads, investor-friendly structures and a potential pickup in private debt transactions for non-sponsor-backed companies.

"What happened on the macro level has made the syndicated loan market very difficult to navigate, and we have seen very little activity on the syndicated side [in recent weeks], due to the difficulty to price deals," said Jake Mincemoyer, head of US leveraged finance at Allen & Overy. "The direct lending market has also slowed up a bit, as matching equity valuations has been challenging on the M&A side and there have been fewer deals to finance."

US companies have issued $132.7 billion of leveraged loans this year through May 18, while in the first quarter of 2021 alone, leveraged lending totaled over $167.8 billion, according to Leveraged Commentary & Data.

Other investors said they still see a pipeline stuffed with pending deals, as cash-rich private investors are taking advantage of lower valuations to make new acquisitions. Even so, these investors acknowledged that borrowers' cash flows face pressure in the coming months, which could affect their ability to keep up with debt payments.

As market dynamics have shifted in recent weeks, key lending rates have risen. Three-month Libor topped 1.5% on May 19, the highest since March 2020. The Secured Overnight Financing Rate, or SOFR, has also hovered around a two-year high in the last two weeks.

As the Federal Reserve raises interest rates, borrowers will bear the brunt of higher cost of capital, especially companies in industries like consumer products and media and entertainment, where it's traditionally difficult to pass along costs to customers, said Ramki Muthukrishnan, who heads the US corporate leveraged finance team for S&P Global Ratings.

Meanwhile, inflationary pressures are expected to persist for some time, squeezing companies in cyclical sectors.

Last-12-month EBITDA growth reported by speculative-grade companies in North America has decelerated across most sectors since the third quarter of 2021, and will continue to slow this year, said Hanna Zhang, an S&P analyst.

Some analysts have forecast a slight increase in corporate borrowers defaulting on their debt obligations.

Default rates among higher-risk companies could reach 3% for the 12 months ending March 2023, compared with the 1.4% default rate through March 2022, according to S&P's most recent outlook for speculative-grade corporate debt. Even with that increase, however, the rate would still be lower than in some previous downturns such as the 2008 financial crisis, when the rate soared into the double digits.