The mergers and acquisitions surge witnessed at the end of 2013 continued through 2014 and drove overall global mergers and acquisitions activity to 2007 pre-recession levels. By many accounts it was been a banner year for mergers and acquisitions. The virtually continuous deal flow was a driving force in creating a very robust volume of loan issuance, and a significant portion of 2014’s acquisition financing was backed by leveraged loans and high yield issuance.
Approaching 2014 year-end, Standard & Poor’s Leveraged Commentary and Data Unit reported the volume of leveraged loan issuance for 2014 at approximately $529.5 billion. Although the results did not reach the record issuance of $606.7 billion posted in 2013, the issuance volume greatly exceeded 2007’s issuance peak. Nevertheless, the results are not reflective of fourth quarter performance, which struggled due to, in part, a steady stream of investor withdrawals from leveraged loan funds. Similarly, high-yield issuance had a strong performance during the first three-quarters of 2014, according to the Securities Industry and Financial Markets Association, new issuance was $278 billion through October. The last quarter of 2014, however, included significant high-yield selloffs in October and December that slowed issuance. The lack-luster fourth quarter resulted in an issuance volume trailing behind 2013’s gross high-yield issuance of $340 billion. Indeed, according to data from Barclays PLC, high-yield returns finished in the negative for the year, which hasn’t occurred since 2011.
The Board of Governors of the Federal Reserve System (the “FRB”), Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation, have attempted to dampen performance in leveraged financing by issuing warnings to banks and stepping-up oversight. Indeed, the FRB chair, Janet Yellen, issued a warning that both high-yield and leveraged loan issuance were in “bubble” territory. The FRB has also signaled that an interest rate hike is expected in 2015, but that it would wait “patiently” for the right time. In the ordinary course, when interest rates climb the price for existing bonds conversely falls and, therefore, a significant rise in interest rates could make high yield prices plummet.
In the first half of 2014, the difference in yields between Treasury and high-yield bonds was low and so were defaults. However, in the latter half of 2014, the increasing stress in the market caused the yield spread to grow over 5.5%, in comparison to the approximately 3% difference in June. The growing yield spread signals a weakening demand for high-yield and an increased investor demand for a yield high enough to hedge risks. It is the largest spread since late 2012. Historically, the difference between the two yields typically rises when turnaround activity sees an uptick. The savings-and-loan crisis, the dot-com crash, and the 2008 financial crisis, each occurred in the wake of interest rates on high-yield being low relative to Treasury bonds.
Falling Oil Prices
Fourth quarter performance in leveraged loans and high-yield was heavily affected by the failing energy sector, with the U.S. high-yield market appearing as one of the main casualties. Energy debt accounts for 16% of the $1.3 trillion U.S. high-yield market and the declining oil prices drove high-yield prices to fall 8% since late June. Energy companies were a notable participant in the high-yield market this cycle and companies took advantage of cheap debt to finance exploration and new production. According to Thomson Reuters LPC data, 2014 lending to oil and gas companies totaled $465 billion – the highest annual total ever, and 29% higher than the previous record high of $359 billion in 2007. In the past few months, however, with signs that supplies were outstripping demand, the secondary market has taken a hit due to falling oil prices and the implications for the high-yield and leveraged loan markets has drawn attention.
U.S. crude oil prices falling below $55 a barrel from over $100 barrel in June took a toll on the price of energy-related stocks and credit instruments and the speculative-grade oil and gas firms as investors unloaded their debt. After the Organization of the Petroleum Exporting Countries’ (“OPEC”) Thanksgiving decision to keep production quotas at 30 million barrels per day rather than cut output, the collapse in energy debt accelerated. OPEC’s decision has exacerbated the challenges for oil field services companies and U.S. shale drillers. Both Brent crude and West Texas Intermediate crude, grades of crude oil used as a benchmark in oil pricing, plunged the day after the OPEC’s announcement.Additionally, in comparison to the current 5.5% yield spread in the broader high-yield sector, energy bonds currently yield in excess of 9% more than comparable Treasury bonds.
Energy debt investors are faced with the stark reality that the falling oil prices may begin to bear on the credit, operations and liquidity of oil and gas issuers and it could become difficult for some companies to meet covenants on existing loans and banks may begin to ask for extra protection on future deals. Distressed debt investors that we contacted appeared to be busier during the month of December than they had been in several years, with several reporting a larger potential pipeline of activity than they had seen in years.
As others have noted, the current state of the high-yield market may prompt investors to reduce their exposure across all other industry sectors. According to The Wall Street Journal, each of the 21 high-yield sectors, not just energy, registered losses in the early part of December. Investor fears resulted in the dumping of energy bonds at staggering levels. As of the date of this article, investors have pulled loans in several energy-related financing deals. Additionally, funds holding high-yield have experienced huge outflows since June, with more than $17 billion removed from the market. The recent selloff of high-yield has given rise to speculation that other assets – including energy stocks – may also be in distress. Lastly, of course, we should all remember that there are trillions in energy derivative contracts looming, and someone will be on the losing end of those contracts with the dramatic drop in oil prices. All of this together certainly promises to bring more activity in the energy sector in 2015.
The Year Ahead
Does all of this mean a busier year for corporate restructuring activity? The truth is that no one knows for sure, but it’s the first time in a long time that principals and professionals who have been through prior cycles have seen such a large number of factors in play that could cause an uptick in activity. It’s noisy in the restructuring world in our humble view, and a large number of smart, aggressive players are busy looking at a number of prospects, raising money and waiting to pounce. 2014 also was the first year that we can recall there being such a large number of companies with restructuring activity with debt in play that was issued after the financial crisis. The chasm from boom to bust in an era of easy credit and little-or-no-covenants certainly makes for surprises not tied to a traditional maturity wall. Comfortable to say that 2015 is a time to be vigilant and aggressive. We wish much success for those with an appetite for risk, and we wish everyone much personal and professional success in 2015.
A version of this Bankruptcy Blog post was originally published on the Journal of Corporate Renewal, and can be accessed here.