Economies are strengthening and the outlook is probably the best it has been in 10 years, but there can be no room for complacency in the debt market.
Although there will be turbulence next year, the big difference is the improved global economic picture. This is reflected in the IMF's November report, which raised growth forecasts to 3.6 percent this year and 3.7 percent in 2018.
The momentum is set to continue into 2018, although the dynamics could change on the back of rising interest rates in the US and UK. The steady stream of refinancings could ebb, although the European loan market is expected to remain an attractive market because the ECB has no plans to raise interest rates until mid-2019. It is gradually halving its monthly bond buying programme to €30 billion, which means there will still be plenty of liquidity in the system.
However, any slowdown in refinancing is likely to be offset by a robust pipeline of M&A deal flow; strong CLO demand; broad investor appetite for leveraged loans; and a positive macroeconomic outlook across most of Europe, according to a report from Moody's released in November. In addition, the liquidity profile in the EMEA non-investment-grade universe should be solid next year, while the European default rate is likely to stay below 2 percent. This is due to improving credit quality, positive economic fundamentals and industry outlooks. Other contributing factors include low refinancing risks, stability in commodity prices and a relatively low high-yield spread. There may be defaults, but they will be isolated and occur among companies vulnerable to event risks or in weak sectors.
Market participants are also optimistic on the outlook for both US and European high yield debt due to an improving global economy, which has increased the likelihood of more upgrades than downgrades in ratings.
Regulations could take their toll, especially the ECB's guidance on leveraged transactions, which is being introduced to rein in risky bank lending and is similar to the US Leveraged Lending Guidelines introduced in 2013. While some details are clear, including the definition of leveraged transactions as all types of loans or credit exposure with leverage of more than four times total debt to EBITDA, many questions are still outstanding. The most notable are the definition of total debt and the impact of the regulation on acquisition finance and banks' internal systems due to the introduction of a stricter 90-day limit for syndicating deals.
In addition, concerns persist over the statement that highly leveraged loans with leverage of six times total debt to EBITDA should remain exceptional, because many loans could fall into this category without further clarification.
One of the main issues is that the rules could create an uneven playing field in the leveraged finance space. For example, European central banks may put their own spin on the interpretation and implementation, while a disproportionately large number of higher leveraged transactions could be undertaken by banks not governed by the ECB's guidance. These range from institutions that do not participate in the Single Supervisory Mechanism (SSM) to those that are not regarded as 'significant' by the ECB and non-bank lenders. If this scenario materialises, it is unclear how regulators and supervisors will react. However, it is unlikely that the ECB would expand the number of institutions it regulates.
An optimistic outlook
Although there could be political headwinds next year, the big difference is the improved global economic picture. This is reflected in the IMF's October report, which raised forecasts for global growth to 3.6 percent this year and 3.7 percent emerging Asia, emerging Europe and Russia.
The picture has not been this positive in Europe for ten years. Leveraged loans and high yield bonds will also benefit from strong investor appetite, low default rates, improved industry outlooks and a relatively low high yield spread.
Demand is expected to remain firm for loans, as the Federal Reserve lifts interest rates further and central banks begin winding down stimulus. However, in the US, all eyes will be on the possible repeal of the US Leveraged Lending Guidelines, which were implemented in 2013 to curb systematic risk in the banking sector by limiting their ability to underwrite highly leveraged loans. Yet this did not dampen investor appetite, and there is a view that relaxing the regulations could shift underwriting volume back to the investment banks, which potentially could lead to larger M&A-related loans.
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