Chapter I
Roots in the Leveraged Loan Market
The CLO market starts with a company that needs to borrow. The company could be a software maker or healthcare provider or in some form of business services or manufacturing. The company may want to refinance debt or buy out shareholders or even acquire another company. So, the company goes looking for a lender and finds that something about the funding it needs—the size, the terms, the business the company is in or something about its balance sheet—does not fit the outline of a routine bank loan. The company needs something beyond the routine. And that takes the company into the leveraged loan market. Once the company becomes a borrower there, it becomes a candidate for all the CLO portfolios trading that market every day.
To understand the path from borrower to CLO and the risk and return profile created along the way, it helps to understand the rapidly growing leveraged loan market. That market has grown in the last decade at a compounded annual rate of more than 10% to reach $1.41 trillion (Exhibit 1.1). While leveraged lending remains a fraction of the $10 trillion in outstanding US investment grade and high yield corporate bonds reported by SIFMA at the end of 2021, it has become an important piece of the US financial system. Although there is an active market in leveraged loans in Europe, too, this guide focuses on the US. But most of the principles at work in the US apply to Europe, too.
Exhibit 1.1: The leveraged loan market has grown 10% annually for the last decade
Note: Primarily institutional tranches. Source: LCD, Santander US Capital Markets
- Leveraged lending has a couple of important pieces:
- A distinct set of borrowers often trying to fund rapid growth
- Banks that originate and syndicate or sell the loans
- Loans structured to meet demand from banks, CLOs and other investors
- Wide interest rate spreads
- A clear track record of repayment, default and recovery
- A broad audience of investors
Borrowers in the leveraged loan market
Borrowers in the leveraged loan market usually fall below investment grade, the strongest tier of credit. The loans are named more for the typical borrower than for the loan itself. Borrowers end up as leveraged or speculative grade credits for a range of reasons. They might show high rates of financial leverage, based on the ratio of debt to operating revenues or EBITDA. They might show low levels of interest rate coverage, judging by the ratio of EBITDA to interest expense. Profit margins and efficiency could be low. The business could be volatile. Company size or total revenue might be modest. Or the company might have only a handful of sources of funding. Any one or a combination of these factors raise the risk that an unexpected turn of events could weaken the company’s ability to repay. Around 69% of U.S. companies representing broad industry groups today hold speculative grades.
Companies come to the leveraged loan market from a wide range of industries. Industries with the largest shares of the market as of mid-2022 included computer and electronic makers, health care providers and business equipment and service providers (Exhibit 1.2). All other industries have shares below 5%. The single largest category of outstanding leveraged loans in went to borrowers that fell into the category of “Other”, capturing all industries with less than 1.4% of the total market. The wide range of industries and their generally low shares limits market exposure to the ups and downs of any one part of the economy.
Exhibit 1.2: Leveraged loans fund companies across a wide range of industries
Note: Share the Morningstar/LSTA Leveraged Loan Index $1.415 trillion par as of 6/30/22. Source: PitchBook | LCD, Santander US Capital Markets
The leveraged loan market caters heavily to companies involved in refinancing existing debt, leveraged buyouts, mergers or acquisitions, recapitalizing the balance sheet or funding general corporate purposes (Exhibit 1.3). Many of these companies could issue high yield debt—and some, in fact, do issue in the high yield market—but leveraged loans typically offer more flexible terms and a competitive floating rate of interest. Flexibility can make a big difference for companies likely to evolve quickly in the years after the loan is made.
Exhibit 1.3: Leveraged companies borrow for different reasons
Note: Share of new leveraged loans YTD through Jun 2022. Source: PitchBook | LCD, Santander US Capital Markets
The industries in the leveraged loan market and the loan purposes often reflect the influence of private equity firms that own or sponsor the borrower, a legacy of the market’s roots in leveraged buyouts. In a leveraged buyout, a private equity firm or other group will buy a company with a combination of equity and debt. The buyer often will arrange debt financing in concert with a bid for the available company. Some private equity sponsors have strong followings among leveraged loan investors and may have a record of injecting equity into companies that need it, for example, or supplementing management teams that need support. Sponsors that tend to make their companies stronger may get a relatively low cost of funds. Other sponsors have less of a following or are known for aggressive financial management, leaving some leveraged loan investors demanding a yield premium to hold paper in the sponsors’ companies.
The lenders and arrangers in the leveraged loan market
As for the lenders in this market, banks made the lion’s share of leveraged loans when leveraged buyouts launched the market in the mid-1980s. But banks in the decade afterwards moved away from the high risk and high reward of leveraged loans. Making loans could still help win business in corporate cash management or capital markets transactions or other areas, so banks gravitated toward the role of loan agent or lead arranger in a loan syndicate. Syndicates can handle bigger loans and can spread risk across a group of lenders. The bank could participate in the loan and get other business but without taking significant risk. The role of arranger also happens to pay well. Arrangers can earn fees of 1% to 5% of the loan commitment depending on the complexity of the deal, market conditions and underwriting. In 2021, for example, banks or their affiliated brokers represented 17 of the Top 20 bookrunners for new leveraged loans (Exhibit 1.4)
Exhibit 1.4: Banks or affiliated brokers dominate bookrunners in leveraged loans
Note: Data show share of total 2021 new leveraged loans by bookrunner. Nonbanks include Jefferies, Antares Capital and KKR. Source: Bloomberg, Santander US Capital Markets
Banks today remain the primary arrangers of loans and major holders, but they have increasingly distributed most of the risk. In 2013, the Federal Reserve, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency issued Interagency Guidance on Leveraged Lending (SR13-3). The guidance outlines best practices for underwriting leveraged loans, syndication, reporting and analytics, portfolio risk management, stress testing and so on. It also encourages a loose definition of leveraged loans including loans for buyouts, acquisitions or capital distributions, loans to companies with a ratio of total debt-to-EBITDA greater than 4x or senior debt-to-EBITDA greater than 3x, loans to borrowers with a high ratio of debt to net worth, or loans to borrowers where leverage ratios significantly exceed industry norms or historical averages. The guidance notes borrowers with debt-to-EBITDA of more than 6x will attract regulators’ attention. And it also suggests borrowers should be able to fully repay senior secured debt or 50% of total debt within five to seven years.
As banks have tightened their leveraged lending, unregulated funds or direct lenders have stepped in. Private lenders have gained market share from banks.
The loan syndication process
Syndicating a loan has become straightforward. The agent may initially approach investors informally about the borrower and get feedback on proposed loan structure and pricing. Unlike bond transactions, the agent on a loan shares private, confidential information about the borrower with potential investors. Even for borrowers with public debt or equity that file with the Securities and Exchange Commission, a leveraged loan credit agreement may only become public when it is filed, often months after it is written and brought to market. Once proposed structure and pricing is set, the agent formally brings the loan to market with flexibility to change some terms and pricing based on market conditions and investor interest. The agent builds a book of interest and finally sets a price to clear the deal.
After a loan is syndicated, the agent still corresponds with the borrower under confidentiality agreements to monitor monthly or quarterly financials, amendment or waiver requests, financial projections and business plans. Much of this information remains private until the borrower either files with the SEC or voluntarily discloses.
The distribution of risk by banks has led to a strong primary market for issuing new loans, and the broadening base of investors has led to an active secondary market. In 2021, for instance, $943 billion in new leveraged loans came to market worldwide (Exhibit 1.5). These loans flowed into a market with multiple brokers willing to buy or sell. Of loans in the market between October 2016 and August 2019, for instance, analysis by Amherst Pierpont shows 27% had only a single market maker while 3% had 10 or more market makers (Exhibit 1.6).
Exhibit 1.5: A robust global market in new leveraged loans
Note: Includes all loans converted to US dollars. Source: LCD, Santander US Capital Markets
Exhibit 1.6: Loans vary in the number of brokers willing to quote prices
Note: Analysis of bid depth based on unique loans in CLOs with facility size greater than $250 million and observed weekly pricing between October 2016 and August 2019. Data from Abrahams, S. and J. Wang, “A new take on liquidity in leveraged loans,” APS Portfolio Strategy, September 6, 2019. Source: Intex, Markit, Santander US Capital Markets
Pricing in the leveraged loan market has become steadily more transparent. In 2000, the SEC required loan mutual funds to start pricing their holdings using market data rather than estimates of the loans’ likelihood of repaying principal. This led to the launch of commercial pricing services that collected data from loan trading desks. At this point, upwards of 90% or more of leveraged loans are priced at least monthly, allowing investors to track investment performance beyond just loan cash flow.
Types of leveraged loans
Lenders and investors distinguish between broadly syndicated loans (BSL) and middle market loans (MML). Some investors draw the line between loan types based on overall size of the lending facility and some based on corporate borrowers’ profile. A broadly syndicated loan often is underwritten by banks targeting corporate borrowers with more than $50 million in EBITDA. A broadly syndicated loan may have anywhere from 15 investors to more than 100 investors in a senior credit facility. In contrast, a middle market loan is underwritten by a single lender or a small club of lenders targeting companies with $5 million to $350 million in annual gross revenue or less than $50 million in EBITDA. The lenders in a middle market loan market could be regulated banks or unregulated private companies, including business development companies, or BDCs. Annual middle market loan new issuance has accounted for only 6.4% of total leveraged loan issuance since 2008 (Exhibit 1.7).
Exhibit 1.7: Middle market leveraged loans make a small but steady share of the market
Note: Middle market loans issued for companies with $350 million or less in annual gross revenue. Source: Santander US Capital Markets, S&P LCD, SIFMA
Seniority and rating
Leveraged loans are secured by some kind of collateral. The collateral includes property, plant, equipment, receivables, inventory and other tangible and intangible assets of the borrower. Loans typically are in the most senior position in corporate capital structure and have the first right of repayment (Exhibit 1.8). A small share of leveraged loans, less than 10%, are second liens that get repaid after first liens. High seniority usually results in better recovery rates if the loan defaults. And loans usually get repaid before bonds if a company is liquidated, so a company can have an elaborate capital structure that gets paid after any loan debt, with each class paid after the ones above it—senior secured bonds, senior unsecured bonds, senior subordinated bonds, subordinated debt, preferred equity and, finally, common equity. While companies’ speculative grade ratings indicate higher default risk, the often-limited loss after a default can make leveraged loans competitive with unsecured credit exposures to investment grade borrowers.
Exhibit 1.8: Senior secured loans have high seniority, low risk in a corporate capital structure
Source: Morningstar/LSTA Leveraged Loan Index Factsheet
Most leveraged loans are ‘BB+/Ba1’ or below at issuance. The mix of loans by rating has changed substantially over time. The broad trend has been toward loans with steadily lower ratings, especially ‘B’ and ‘B-‘ (Exhibit 1.9) The share of ‘B’ and ‘B-‘ loans has gone from 12.8% in December 2008 to 51.4% in July 2022.
Exhibit 1.9: Share of ‘B’ and ‘B-‘ loans has steadily increased since 2008
Source: LCD, Santander US Capital Markets
Features of leveraged loans
A typical leveraged loan consists of two parts:
- A pro-rata loan, and
- An institutional loan
The pro-rata loan includes a revolving line of credit that the company can draw on and repay at will. It also usually includes a loan that amortizes over a fixed term, often called a Term Loan A. The borrower typically pays a range of fees including an annual facility fee, an annual commitment fee on any undrawn portion of the revolving line, and an annual usage fee on the drawn portion (Exhibit 1.10). The arranging bank and other members of the syndicate usually retain the pro-rata loan.
The institutional loan is usually a floating-rate loan with a bullet maturity, often called a Term Loan B. This loan also attracts a facility fee and a usage fee. Institutional loans represent the largest share of annual new loans issued. The institutional loan usually gets sold.
Exhibit 1:10: Key price features of leveraged loans
Source: Fitch Ratings, Gadanecz, B. (2004), “The syndicated loan market: structure, development and implications,” BIS Quarterly Review.
Institutional loan coupons typically float at a spread over an index such as 1- or 3-month LIBOR or SOFR. The spread on a loan is highly correlated to the rating to compensate lenders for credit risk. The weighted average institutional loan spread for ‘BB/BB-‘ loans as of late 2021 stood at 283 bp, according to S&P, while ‘B+/B’ loan spreads stood at 396 bp
To protect lenders against declining interest rates, leveraged loans can also have an interest rate floor. For instance, nearly 55% of loans in the Morningstar/LSTA index in December 2021 had a floor with an average level of 73.4 bp.
Most institutional loans have a 5- to 7-year maturity with little call protection. A soft call provision in leveraged loans often requires only modest premiums for calling a loan in its early years. Some loans in recent years have required no more than 2% premium for loans called in year one and 1% premium in year two. In recent markets, a borrower may pay as little as a 1% premium to call the loan in the first six months. The call feature possibly makes borrowers prefer loans over bonds because it gives the flexibility to take advantage of tighter loan spreads to refinance or recapitalize.
Loan covenants also provide protection to lenders in leveraged loans. There are three types of covenants in traditional loan agreements: affirmative, negative and financial (Exhibit 1.11). Affirmative covenants require the borrower to do things such as provide financial statements, maintain insurance, pay taxes, obey the law and so on. Negative covenants limit the borrower from doing things such as taking on additional debt, issuing stock, paying dividends and so on. And financial covenants require the borrower to hit certain financial targets such as a ratio of debt-to-EBITDA, tangible net worth, debt service coverage and so on.
Exhibit 1.11: Loans can have affirmative, negative and financial covenants
Source: Fitch Ratings
In recent years, covenant-lite loans have become well-established in the institutional loan market. As the name suggests, covenant-lite loans have fewer protections for lenders. The absence of financial maintenance covenants such as maximum leverage, minimum interest coverage, and minimum fixed charge is the core feature of covenant-lite loans. In contrast, incurrence-based negative covenants are more common in covenant-lite loans, and those loans have borrower-friendly terms more in line with bonds. For example, instead of putting a dollar cap on borrowers’ additional debt, covenant-lite loans may allow borrowers to incur new debt if they can meet the incurrence test after issuance. While lenders’ protection is limited in covenant lite loans, lenders may receive a higher yield than a fully covenanted loan. It worth noting that the pro-rata debt including the revolving credit and Term Loan A normally syndicated to banks still have strong covenants today. Investors even in a covenant-lite Term Loan B still have somewhat of a check on the corporate borrower. Based on LCD data as of December 2021, covenant-lite loans represented 87.2% of the outstanding par balance of leveraged loans.
The terms of leveraged loans are often negotiable after the loan closes. A performing borrower, for example, can ask lenders to amend and reprice its loan to a lower spread. A performing borrower might also negotiate to extend the loan maturity. Requests for covenant relief are more likely in a credit bear market. Many businesses affected by Covid-19, for example, saw cash flow drop in 2020. As a result, lenders that year provided a total 193 covenant relief amendments on broadly syndicated loans. When the economy quickly rebounded from pandemic, covenant relief requests fell. All in all, only 30 covenant-relief amendments happened in 2021, the lowest in more than a decade.
The consequences of violating covenants varies. Technical default occurs whenever a borrower fails financial covenants or loan provisions. In most cases, the borrower will work with lenders to get a waiver on the violations. Lenders in turn can ask for fees, an increase in credit spread or a shortening of the loan term. In some extreme cases, lenders have the option to accelerate the debt and force the borrower into bankruptcy. Payment default incurs when a corporate borrower fails to make interest or principal payments. Payment default is more serious than technical default. Leveraged loan agreements typically grant a cure period, such as 30 days. After the cure period, lenders can either provide a loan forbearance agreement or accelerate the loan, which will cause the borrower to declare bankruptcy and possibly restructure its debt.
Wide loan spreads
Leveraged loans come with significant spreads to the floating rate index for both the pro rata loan often retained by the syndicating banks and the institutional loan sold to other investors. Spreads in recent years have ranged from around 200 bp for ‘B+’/’B’ pro rata loans to as much as 500 bp for ‘BB’/’BB-‘ loans (Exhibit 1.11.A). The high spreads reflect the leverage of the borrowers and, naturally, the speculative grade ratings. Pro rata loans also typically come to market at tighter spreads than institutional loans, reflecting tighter covenants and higher usage fees. The wide spreads on leveraged loans make them attractive to buyers able to fund at lower rates, including CLOs.
Exhibit 1.11.A: Leveraged loans come to market at wide spreads
Source: LCD, Santander US Capital Markets
Default, losses and repayment
Leveraged loans have seen several waves of default around economic recession. The first came after the bursting of the Internet bubble in the early 2000s when default rates ranged between 6% and 8% for several years (Exhibit 1.12). The second wave came during the Global Financial Crisis when default rates by par loan balance approached a peak of 11%. The third came at the onset of the Covid-19 pandemic when defaults climbed to 4%.
Default rates have also climbed slightly during Federal Reserve hiking cycles as rising interest rates pushed up interest expense on balance sheets largely funded with floating-rate debt. Defaults rose modestly during the cycles of 2004-2006 and 2015-2018.
Defaults rose, too, in 2014 with the default of a large loan to TXU Energy, which pushed the default rate sharply higher when measured by par balance but had limited effect on default rate measured by issuer count.
Exhibit 1.12: The leveraged loan market has seen several waves of defaults
Note: Default rate is LTM total default amount over par outstanding at the beginning of the 12 month period. Includes all loans including those not included in the LSTA/TRLPC mark-to-market service. Primarily institutional tranches. The jump in default rate by par amount in 2014 and 12 months thereafter reflects the default of the TXU Corp. loan. Source: LSTA.
Losses to leveraged loan investors following a default can come through bankruptcy and liquidation of company assets or through a distressed debt exchange. Bankruptcy and liquidation end the issuer’s business and uses proceeds from sale of all assets to repay debt. If proceeds fall short of covering a loan’s par amount, the investor takes a principal loss. A distressed debt exchange involves taking a haircut on loan principal to get new debt from the issuer. For example, the issuer can offer to exchange 100% of an existing 7%-coupon first lien for 80% of a new 8%-coupon second lien. The loss to the investor in the distressed exchange might be less than the loss from bankruptcy and liquidation, and the issuer avoids bankruptcy and lowers interest expense. If the new second lien also has a longer maturity, the issuer puts off the liquidity stress of a large principal payment.
Recoveries after default usually run higher on loans than on other categories of leveraged finance. S&P Global LossStats’ 2021 annual report assessed recoveries in $1.1 trillion in loans and high yield bonds over 32 years. The study discounts recoveries back to the date of default to account for long and variable recovery timelines. Although discounted recovery rates vary over time, the study finds that revolving loans have a higher discounted recovery than term loans, first-lien term loans have a higher discounted recover than second-lien, and covenant-lite loans have a recovery rate lower than average (Exhibit 1.13). The study also finds that loans generally have a higher discounted recovery rate, 79% of par, than high yield bonds, 47% of par.
Exhibit 1.13: Recoveries have varied across high yield bonds and loans 1987-2019
Source: S&P Global LossStat Annual Report 2021
Borrowers also take frequent advantage of the call features of leveraged loans to repay their loans. Repayment rates rise in markets where investor demand for loans tightens spreads and fall in markets where investors step back and spreads widen. Annualized repayments have varied from as low at 9% in the depths of the Global Financial Crisis to as high as 47% just before the energy crisis of 2015-2016 (Exhibit 1.14). Between 2008 and 2021, annual repayments averaged 28% with a median of 27%.
Exhibit 1.14: Annual leveraged loan repayment rates have varied significantly
Source: LCD
Investors in the leveraged loan market
The list of investors participating in the primary and secondary loan market has grown:
Banks
Commercial banks and savings and loan institutions usually participate in the revolving credit in the pro-rata debt. The amortizing Term Loan A has become less common in recent years but remains attractive to some bank investors.
CLOs
CLOs traditionally are the largest investors in the Term Loan B institutional debt market, and the CLO machine has been particularly strong in recent years due to its structural leverage and relatively low funding cost. In 2021, for example, CLOs bought nearly 73% U.S. leveraged loans (Exhibit 1.15).
Exhibit 1.15: CLOs currently dominate primary market institutional loan investing
Note: Data for highly leveraged institutional loans with coupons of L + 225 or higher. Source: LCD, Santander US Capital Markets
Loan mutual funds
Loan mutual funds are the second largest investor in leveraged loans, although the fund share of loans has declined from a peak of 31% in 2013 to roughly 15% at the end of 2021. Loan mutual funds allow retail investors to get exposure to leveraged loans.
Other institutional investors
Insurance companies along with hedge funds, high yield and distressed debt funds and finance companies make up the rest of the investor base, but their share is relatively small compared to CLOs and loan funds. Hedge fund, high yield and distressed debt fund share once reached one third of the total investor base from 2008 through 2011. As the credit market recovered from the Great Financial Crisis and rates and spreads declined afterwards, the average yields on leveraged loans no longer fit those funds’ return profile. Instead, investing in the equity tranche of CLOs makes more sense for hedge funds today rather than investing in loans directly.
The backdrop for CLOs
The ebbs and flows in the borrowers that come to the leveraged loan market and in the lenders and investors that sponsor it form the backdrop for the CLO market. Loan performance becomes CLO performance. Through CLO structure, investors can dial that performance up or down. And that brings us to the next chapter.
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