Leveraging costs and structures have become increasingly volatile, as markets react to rising economic growth, inflation concerns and trade tensions.
The new Fed chair, Jerome Powell, continued the monetary policy “normalization” begun by the prior Fed chair, Janet Yellen, increasing rates another quarter-point in March.
U.S. inflation is firming around the Fed’s target level of 2.0% year-over-year growth, as the CPI has risen an average of 2.25% year over year in the first three months of 2018. UK inflation of 3.1% is running above target, with similar growth and inflation concerns in Europe having surfaced.
Concern that the markets may be underestimating economic growth and inflation and, in turn, the likelihood that central banks will need to act more quickly, has investors on edge, pressuring corporate borrowing rates and valuations.
Rising Treasury yields have translated into higher corporate borrowing rates for large-cap financings, with high-yield bond indices having risen nearly 50 bps in the first quarter.
Demand for illiquid middle-market new issuance has been robust. The large amount of debt fund “dry powder” is overwhelming the relative dearth of issuance, creating a window for issuers to achieve growth- and recap-related financings on inordinately attractive terms and structures. While we anticipate more tepid public market conditions to ultimately spill over into the illiquid markets, the prevailing differential represents a notable window of opportunity.
In Janet Yellen’s final meeting as Fed chair in January, the Central Bank held interest rates flat but expressed anticipation of more aggressive inflation than previously forecast. While the benchmark interest rate remained unchanged, Treasury yields began to rise rapidly, triggering a significant equity market correction (–7.5% S&P 500 peak to trough). New Fed chair Jerome Powell’s remarks to Congress in February regarding his view on monetary policy further affirmed investor concerns of accelerating economic growth and the potential for less gradual rate hikes. From the beginning of January to its late February peak (2.96% yield), the 10-year Treasury note rose 55 bps (a 23% change). The 10-year note subsequently sold off as fears of trade tensions intensified, settling at 2.74% at quarter-end.
Rising rate concerns weren’t limited to the U.S., as the Bank of England warned of earlier, and larger rates hikes for the UK with inflation having run far above target, hitting a five-year high of 3.1%. In continental Europe, strong economic data is convincing investors that central bankers will have to tighten monetary policy, despite contrary messaging.
With rapidly rising base rates posing a major risk, high-yield bond yields jumped 47 bps (an 8% increase) over the quarter and large-cap leverage loan yields increased a more modest 12 bps (a 3% increase). The rise in large-cap bond yields occurred despite a further lowering in default rate expectations. As of March 2018, the U.S. high-yield default rate stood at 3.9%. Moody’s forecasts that rate to decline to 1.7% by March 2019, based largely on continuing earnings growth expectations.
The back-up in large-cap leverage conditions and the equity market volatility notwithstanding, demand for illiquid middle-market new issuance has been robust across the U.S., UK and Europe. As of late 2017, North American-focused debt funds had approximately $143 billion in dry powder, a 10% increase from the beginning of 2017. This surge in private market capital availability has, for the moment, overwhelmed the relative dearth of issuance. As a result, we have observed highly favorable rates and structural terms for issuers in recent offerings, as well as a strong bid for middle-market leveraged recapitalizations and acquisition-related financings. We believe the window for middle-market issuers and sponsors to enjoy current market conditions will be transitory as broader market dynamics ultimately spill into the middle-market.