CHAPTER 1

AN OVERVIEW OF LEVERAGED FINANCE

William F. Maxwell

Rauscher Chair in Financial Investments, Cox School of Business at SMU

Broadly defined, leveraged finance deals with the riskiest forms of debtfinancing. These encompass original issue debt from investment-bank-issued debt,high-yield bonds, or bank-issued debt (leveraged loans), and debt that hasfallen from investment grade to high-yield status ("fallen angels"). Creditdefault swaps also play an important role in these markets because they arederivative contracts deriving their value from the risk of default on specificfirm debt or aggregate default risk. As such, they provide an alternativemechanism for investors to take short or long positions on the underlyingassets.

The modern high-yield bond market began in the early to mid-1980s when DrexelBurnham started issuing bonds, which were rated high yield at issuance. Beforethis time, high-yield bonds consisted of "fallen angels." Since the mid-1980s,the high-yield market has gone through significant changes and upheavals, andthe market has evolved from being solely based on high-yield bonds to being abroader and more diverse market. Leveraged loans (the equivalent of high-yieldbonds issued by banks) and credit default swaps (default-triggered derivativeinstruments) became prevalent in the market in the middle to late 1990s.

The leveraged finance market has always been a volatile market, with the marketexperiencing significant boom and bust periods. It is not surprising then thatthe leveraged finance market as well as all aspects of the financial marketexperienced dramatic upheaval during 2008. In 2008, the high-yield bond,leveraged loan, and credit default swap (CDS) indexes were down by 27%, 29%, and13%, respectively. However, the high-yield bond and leveraged loan marketsrecovered with historically high returns of 50% in 2009. In addition, 2009 was arecord year for high-yield bond issuance, but it also evolved back closer to itsroots with the virtual disappearance of leveraged loans. Even after thefinancial market meltdown in 2008, it is clear that leveraged finance remainsone of the cornerstones of financial markets.

Leveraged finance is a large and significant component of the fixed-incomemarket. It has grown dramatically since its inception, and there were $864billion and $1.64 trillion in high-yield bonds and leveraged loans outstandingin 2007. In total this represents 8% of all fixed-income assets (see Figure1.1).

Debt is the primary source of external capital for public companies. Within thebroader category of debt financing, leveraged finance is the predominant source(Table 1.1 provides issuance volume by security class). It is clear thatleveraged finance (high-yield and leveraged loans) is the primary source ofcapital. However, there is significant variation in the proportion of newfinancing associated with leveraged finance over time. During down economicperiods, access to these markets is limited. This is apparent as issuance volumein the leveraged finance market can drop significantly in down periods.

What also is apparent from Tables 1.1 and 1.2 is that there hasbeen dramatic growth in the use of leveraged loans. (Some of the leveraged loansissuance volume can be misleading because it includes "revolvers." These are acommitment by the banks to issue short-term debt, less than a year to maturity,but rarely do firms fully draw on these "revolvers.") The growth of leveragedloans is the result of the introduction of the institutional leveraged loanmarket, loans that are syndicated to nonbank institutions. Until the late 1990s,leveraged loans were issued by banks with the loans typically being syndicatedto other banks. In the late 1990s, loan documentation was standardized, whichpermitted the development of a secondary market in bank loans. This wasnecessary before nonbank institutional investors would purchase the securitiesin either the primary or the secondary market. In addition, the late 1990s andearly 2000s led to an increased demand for securitized products. Given thematched payout structures and variable rates of leveraged loans and securitizedproducts, there was a strong demand for leveraged loans, which were thenpackaged into collateralized loan obligations (CLOs). With these developments,the leveraged loan market exploded (see Tables 1.1 and 1.2).

The sizes of the leveraged loan and high-yield bond market were roughlyequivalent in 2004 (Table 1.2). But by 2007, the leveraged loan marketwas 2.5 times larger than the high-yield market in terms of new issuance.However, the financial meltdown in 2008 brought about a fundamental shift backto the issuance of high-yield bonds away from leveraged loans for corporations.While new issuance volume dropped dramatically for both high-yield bonds andleveraged loans in 2008, this shift was more pronounced in the leveraged loanmarkets as bank capital was seriously constrained. This trend continued into2009 as the high-yield bond market experienced a historical peak of new issuancevolume while the leveraged loan market was next to nonexistent.

The Increasing Use of High-Yield Debt as a Financing Source

As we note above, until the mid-1980s firms had very limited ability to issuehigh-yield bonds. Since this constraint has been relaxed, there has been a hugegrowth in the market as more firms restructured, were acquired, or graduallyadded leverage to their financial structures. In doing so, firms and acquirersrelied more on debt financing, and thus we see on average more debt in thecapital structure and lower bond ratings. One way to demonstrate this change isto look at the percentage of U.S. industrial publicly traded firms by ratingclass over time. We track this information over time from the early stage of themodern high yield market, 1986, through 2008 (Table 1.3). In viewingTable 1.3, what is readily apparent is the structural shift in creditratings over time. Across the board, bond ratings have declined. For example,the highest level of credit rating (AAA–A) represented over 30% of U.S.industrial firms in 1986. This had fallen to only a little over 11% by 2006.Accordingly, the total level of investment-grade firms fell from 47% in 1986 to33% in 2006. This trend reversed slightly by the end of 2008 because firms hadsignificant concerns about accessing the capital markets during what is expectedto be a protracted period of economic uncertainty.

Looking at the overall percentage of firms by rating class can mask some of thevariation that we see over time in the new issuance market, which reflects thedemand for a particular level of rating quality at that time. In Table1.4, we show how the variation in rating class within the high-yield marketcan vary over time. For example, in 1991 77% of high-yield bonds issued wererated BB, and only 13% were rated B. In contrast, in 2006 only 39% were BB andthe majority, 53%, were rated B. Part of the trend reflects differences inacquisition activity. During periods of increased leveraged buyouts (LBOs) andmergers and acquisitions (M&A) activity, firms are being financed at the lowerend of the rating spectrum. Other differences reflect demand-drivenconsiderations from the capital markets. During periods of higher defaults, itcan be difficult for firms to issue debt in the lowest rating classes (B andbelow).

The Demand for Leveraged Finance

The increased use of leveraged finance is a function of investor demand.Leveraged finance provides investors with a correlation structure that isfavorable to other asset classes, an attractive risk/return profile, and aconstant income stream.

Table 1.5 presents the correlation structure of various asset classesover the last 10 years and includes two significant downturns in the high-yieldmarkets. It is apparent that both leveraged loans and high-yield bonds have alow correlation with traditional fixed income and, in fact, have highercorrelations to stock indexes. Overall, the leveraged financial markets fitsomewhere between traditional fixed income and stocks as an asset class and thusprovide investors with an attractive asset class in which they can diversifyrisk.

Even more important, the leveraged finance market has provided an excellentrisk/return profile for investors. Table 1.6 provides informationregarding the long-run risk versus return trade-off of the leveraged loan andhigh-yield bond markets. When examining a risk versus return measure, the Sharperatio, the leveraged loan, and the high-yield market have produced asignificantly higher Sharpe ratio than either a large-cap (S&P 500) or small-capstock index (Russell 2000).

Finally, most leveraged finance products provide significant yearly cash flowsto investors. This is attractive to investors seeking current income from theirportfolios. Overall, given the low correlation and impressive risk and returntrade-off, it is not surprising that investors continue to demand leveragedfinance products. Hence, while the issuance of leveraged finance products mayvary over the economic cycle, it is apparent that it is an ever growing presencein the financial markets.

Resilience of Leveraged Finance

Even after the most significant financial crisis since the Great Depression, itremains clear that leveraged finance is an integral part of the world'sfinancial markets. The leveraged financial markets not only survived their mosttumultuous period, but they have in fact recorded a record year of issuance inthe high-yield market in 2009. High yield remains the predominant rating forU.S. industrial firms issuing bonds. It offers an impressive risk/return metricfor investors. Hence, while leveraged finance will continue to evolve over time,it will remain one of the predominant asset classes for investors and companies.

CHAPTER 2

THE COMPONENTS OF THE LEVERAGED FINANCE MARKET

William F. Maxwell

Rauscher Chair in Financial Investments, Cox School of Business at SMU

In this chapter, we examine the growth of the main components of the leveragedfinance market and how they have evolved over time. We begin by discussing thehigh-yield bond market. Second, we examine the leveraged loans market, andfinally, we examine credit default swaps.

High-Yield Bonds

As a viable new issuance market, the high-yield market began in the mid-1980swith the rise of Drexel Burnham Lambert. The market has gone through a number ofpeaks and valleys as periods of easy financing have been followed by higherdefault rates. For example, new issuance volume from 1986 to 1989 wasconsistently around $30 billion with much of the proceeds used to funds theleveraged buyouts (LBOs) market during that time (see Table 2.1). Butthe economy slowed in the late 1980s and into the early 1990s, which led to asignificant peak in default rates, over 9% in both 1990 and 1991. During thisperiod of time there was very little new issuance volume, and the total marketvalue of high-yield bonds outstanding actually decreased from 1990 to 1991. Asimilar pattern emerged around the economic downturn in the early 2000s. On acompressed scale, we see a similar bust and boom period in 2008 and 2009. Whatis of interest to note is the lagged relation between default rates and high-yield markets. Default rates lag according to the economic condition of thehigh-yield bond market.

New issuance patterns are also related to the overall cost of debt capital,which is driven by macroeconomic factors, the government cost of debt, and therisk of a particular asset class defined by the spread relative to Treasuries(the spread is measured as the additional yield for an asset class above andbeyond the government yield of a similar maturity). The correlation amongspreads, new issuance patterns, and default rates is easy to see when oneexamines Tables 2.1 and 2.2.

Spreads can vary significantly over time as demonstrated in Table 2.2.For the BB category the spread varied from a low of 206 basis points in 2006 to591 in 2002 to a high of 1,182 at the end of 2008. There has been even greatervariation in the B category as the spreads were as low as 313 in 2006 and ashigh as 1,698 in 2008. These spreads can also change very quickly. The 2006 to2009 time period demonstrates this phenomenon. It is also interesting to notethat the spreads in the BB and B categories don't move in lockstep, thusdemonstrating the segmented nature of the markets.

As shown in Table 2.3, the characteristics of the new issue high-yieldbonds also vary over time. The percentage of senior debt has ranged from 67% in1997 up to 99% in 2009. The market for deferred interest types of securitiesvaries across credit cycles because these are typically some of the riskiesttypes of issuances. As seen in Table 2.3, deferred securities are attheir lowest when defaults are at their highest (2001–2002 and 2009).Acquisition issuance volume follows a similar cyclical pattern. Finally, foreignissuance in the U.S. market had been decreasing after 2003, which does notreflect decreased demand for the product but instead reflects the rise of high-yieldfinancing in Western Europe and even more recently Asia. This trendreversed in 2009 as foreign firms once again found the U.S. market the easiestto access.

Voluntary debt retirement by issuing firms either through tendering or callingbonds is related to the cost of debt, and thus voluntary retirement is alsorelated to new issuance volume as the firms retire one debt and replace it withcheaper debt. Table 2.4 provides historical measures of voluntary debtretirement. It is apparent that debt retirement can be a significant issue as itcan range up to almost 12% of the market. Second, while there is significantvariation across time, there has been a general upward trend since 2002. Thischanged dramatically in 2008 and 2009 during the financial crisis.

A natural question is, who owns high-yield bonds? The largest investor groupsare insurance companies, pension funds, and high-yield mutual funds, which inaggregate represent approximately 60% of the market. Other significant groups ofinvestors are investment, equity, and income mutual funds; collateralized bondobligations (CBOs); and hedge funds.

Leveraged Loan Market

Leveraged loans have expanded dramatically since the early 1990s. Until thattime, leveraged loans were the exclusive domain of banks. Banks would issueloans and syndicate the majority of the loan to other banks, but the risk ofthis pool of securities could be shared only by other banks, which have alimited demand for speculative-grade debt. Therefore, the overall market waslimited by the demand for such debt by banks.

The market for nonbank leveraged loans began to develop in the mid-1990s becauseof three factors. First, loan documentation and terms were standardized. Beforethis time, any sale of bank loans in the secondary market required the use ofattorneys to draw up sale documents for every transaction. This was both costlyand time consuming. The standardization of the contracts permitted thedevelopment of a secondary market in bank loans. This was necessary beforenonbank institutional investors would purchase the securities in either theprimary or the secondary market. Second, banks were aggressively pursuinglucrative fee-based services, and leveraged loans along with high-yield bondsproduce significant fee income. Third, the growth of securitization allowedleveraged loans to be repackaged into collateralized loan obligations (CLOs)with multiple tranches and risk characteristics. These changes led to thedevelopment of the institutional leveraged loan market in which banks set up thefinancing and syndicated the loan to nonbank institutional investors. With thisdevelopment, the leveraged loan market exploded (see Tables 2.5 and2.6). In 1994, the total size of the institutional leveraged loan marketwas $16 billion. This market grew and overtook the traditional noninstitutionalleveraged loan (bank) segment of the market in 2006 and stood at over $1trillion by 2007. The financial crisis in 2008 has led to a significant drop inthe amount of capital that banks are willing to commit to the leveraged loanmarket. In addition, the demand for CLOs has disappeared. This has lead to ashift back toward the bond market by issuers.

Similar to the high-yield bond market, the Western European leveraged loanmarket has grown dramatically as well (Table 2.6). Because this is anewer market, the percentage of growth of new issuance volume has been evenfaster in Western Europe than in the United States since 2002.

As we noted previously, CLO growth is intertwined with the growth of leveragedloans as CLOs bought the majority of new issuance leveraged loans until 2007(see Table 2.7). The securitized market for almost all productsvirtually shut down in 2008 and 2009. This, along with banks' decreased capitalcommitment, led to the significant drop in new issuance volume in 2008 and 2009.Prime rate funds were the second largest buyer of leveraged loans until 2006.Hedge and high-yield funds were essentially nonexistent buyers in the marketuntil 2002, but they became the second largest buyer, supplanting prime ratefunds, by 2006.

One of the reasons for the explosive growth associated with CLOs was the spreaddifference between similarly rated CLO tranches and traditional high-yield bonds(Table 2.9). In some instances, the spread difference between CLOs andbonds was more than the spread on the BB bond itself (1999, 2003, 2004). Thisclearly indicates that institutional investors believed that similarly rated BBCLO tranches were significantly riskier than the rating agencies or that theCLOs were mispriced. Given the collapse in the value of CLOs in 2007 and 2008,it is clear that the rating agencies underestimated the risks.

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