The COVID-19 crisis has hit businesses all over the world, impacting their ability to raise financing. Both lenders and borrowers are facing challenges, with the shutdown of businesses impacting the credit ratings of companies and their investments and loans. One of the sectors that witnessed a substantial hit is leveraged finance, wherein a variety of instruments saw ratings downgraded in April and May 2020. This has affected both investment sentiment and the ability of businesses to raise additional debt.
The impact on the ratings of leveraged finance has trickled down to fixed income, particularly bonds. At the peak of the pandemic in March 2020, US 10-year yield bonds hit all-time lows, ringing alarm bells among bondholders. Interest rates fell because of the Federal Reserve’s injection of liquidity into the economy, in turn affecting the earnings outlook of high-yield bonds. The chances of recovery looked bleak in April and May; however, fixed income markets began seeing a V-shaped recovery thereon, with emerging markets and bonds in these countries showing signs of a rebound. The fixed income market of a country serves as an indicator of its inflation situation, and a fall in long-term bonds would affect monetary policy and the economy.
The fixed income market is showing definite signs of a recovery as macroeconomic factors around the world see improvement. While most countries saw economic contraction in 2020, markets expect some growth in 2021, albeit on a lower base. This has resulted in a rally in the fixed income market, as investors are looking to add this security into their portfolios, particularly after the volatility seen in stock markets in recent times. As a result, the leveraged loans market, too, has been seeing a recovery, with the credit spreads of high-yield bonds, investment-grade bonds and other bonds beginning to tighten. There has also been a noted decline in the number of downgrades related to leveraged finance instruments. The default rate for leveraged loans and finance reduced to 3.9% in November, according to a report by PineBridge, much lower than the default rates anticipated in May.
The amount of debt raised through private issuances is likely to see a reduction in the short term – in line with the trends seen during the global financial crisis of 2008-09, following which private debt issuance as well as the completion of deals backed by private debt witnessed a large decline. This situation did not last for long, but it could see a temporary return as firms look to avoid raising additional debt. The crisis may, however, be an opportunity for private lenders to provide distressed lending and mezzanine financing to companies. Many companies – especially small and medium enterprises – are under tremendous pressure, and private debt could be made available to such firms. Private debt lenders would be looking to profit from a situation where a V-shaped recovery in the economy allows them to earn a higher amount in a shorter period of time on the back of the expected recovery.
The pandemic has had a substantial impact on the leveraged finance, private debt and fixed income markets. Although debt instruments are being frowned upon at present, they remain the only option for many companies, as raising equity may be difficult until pandemic-related uncertainties subside. All three markets saw large declines, and a similar rise in prospects from March 2020 as the economic recovery being led by the Federal Reserve takes shape. 2020 was a watershed year and should serve as a warning for the three markets on the impact such black swan events could have on them.