Leveraged finance markets have significant credit headwinds yet continue to be resilient and adaptable. Following two decades of supportive conditions, challenging market dynamics have arisen in the past two years, most notably from central banks' historic pace of interest rate increases, slowing economic growth, the end of COVID-19 era stimulus, and a highly volatile geopolitical environment. This has created a new scenario for credit markets that is far less liquid and more challenging than before.

Higher for longer means that hyper-liquid credit markets--investments refinanced to adapt to changing credit conditions with great ease--are a hallmark of the past. This shift to longer hold periods has prompted market participants to recognize the wisdom of Kenny Rogers: "You've got to know when to hold 'em/Know when to fold 'em."

Decreased liquidity and slowing market dynamics have elevated the importance of assessing secondary markets as an indicator of market health, especially when considering the viability of an exit strategy. The behavior of pricing--such as the average bid, the bid/ask spread, and the share of loans in distress--provides real-time insight into market sentiment.

As such, S&P Global Ratings' Credit Research & Insights has established a proprietary analysis of secondary market data for leveraged loans and is introducing bi-weekly research on secondary market pricing to provide transparency on evolving market dynamics. This bi-weekly publication, analyzing loan pricing from S&P Global Market Intelligence Loan Pricing Data, provides data-driven insights on loan secondary market pricing based upon seniority (first lien vs. second lien) and currency (USD vs Euro denominated).

Our Surveillance Of Loan Secondary Market Liquidity

For this bi-weekly research, we aggregate weekly datasets from S&P Global Market Intelligence Loan Pricing Data, combining features from S&P Global Market Intelligence Loan Reference Data.

To create the various aggregates included in our analysis (USD first liens, second liens, distressed, etc.), we screen leveraged loan tranches in the dataset on several criteria, including market depth, facility currency, lien type, and spread, among others.

Our liquidity research enables bespoke risk assessment within the leveraged finance markets. By tracking secondary market pricing metrics--such as the bid/ask spread, bid depth, and distressed ratios--in various cuts of the data, we get a clearer signal on overall market health and current market liquidity. Our myriad approach to aggregating the data provides a multi-faceted perspective on liquidity risk in the market.

For the purposes of our research, we define distressed loans as those with spreads greater than 1,000 basis points.

All loans in our dataset are defined as all USD/EUR first lien/second lien loans meeting the sampling criteria.

To view these exhibits and related research, visit spglobal.com/ratings/PrivateMarkets.

Market Participants Settled In For The Bumpy Ride

Market conditions remained challenging last year as credit headwinds persisted. But leveraged loan market participants seem to have gained confidence that they can navigate challenging credit conditions. The average bid for all leveraged loans rose 330 basis points from 95.23 to 98.53 over the year, and equally significant, 76% of loans were priced near par (98.00 or above) at year end versus 26% when the year began (see chart 1).

Chart 1

Regional differences also began to narrow over the course of 2023 (chart 2). The U.S. dollar (USD) denominated market is larger, deeper, and more diverse than the Euro denominated (EUR) market, and, during 2022, the Russia-Ukraine war magnified concerns about the stability of financial conditions in Europe. At the end of 2022, the average bid for EUR denominated first-lien term loans was 93.8, nearly two points below USD peers, which had an average bid of 95.72.

However, over the first three quarters of 2023, not only did the average bid for both USD and EUR denominated loans rise steadily, but by late September EUR denominated loans had narrowed the gap to just 12 basis points, rising 460 bps to 98.40 in comparison with the USD first liens, which had climbed 280 basis points to 98.52.

Chart 2

European loans have been markedly more negatively affected by the market implications of the Israel-Hamas war than U.S. loans have been. The average bid for EUR first liens dropped as low as 97.04 in the weeks after Oct. 7, 2023--more than a full point below the end of September--and failed to regain their September high over the fourth quarter, ending the year at 98.04. In contrast, USD first liens fell about 35 bps in the following weeks but rallied to end the year at a high of 98.78.

As a result, the gap between USD and EUR first-lien term loan average bids closed out the year at 74 bps, less than half the gap when 2023 began, but far wider than the year low of 12 bps at the end of September (see chart 3). Clearly, market confidence in European credit conditions remains less certain as the proximity and potential exposure to geopolitical conflicts in Ukraine and the Middle East cast a looming shadow on the regional outlook.

Chart 3

The diverging regional response to market shocks has been noted by S&P Global Ratings' Credit Conditions Committees (CCC) over the past several years. Earlier in 2023, the collapse of Silicon Valley Bank (SVB) also instigated different responses between the U.S. and European markets, with the latter counterintuitively more negatively affected than the former. On March 10, 2023, just before the SVB crash unfolded, the average bid for USD first liens was at 97.04, up more than a point and a half from 95.72 at the start of the year. Meanwhile, EUR first liens were at 96.10, up more than two points from 93.80 at the start of the year.

The divergence continued following the bank's failure as contagion spread across the sector. During the week of March 17, USD first liens average bid fell 74 basis points to 96.30 and the EUR average bid fell similarly, 83 bps to 95.26. The next week, the USD average bid fell three bps and the EUR average bid fell 25 bps. By the week of April 14, the USD average bid had regained its pre-SVB footing at 97.13. But the EUR average bid took another four weeks to regain ground; it did not surpass its pre-SVB level, until May 12, at 96.14.

During the year, the average bid/ask spread for EUR first liens also remained wider than that for USD but regained ground finishing 50 bps tighter at 1.08. The average bid/ask spread for USD first liens finished the year 30 bps tighter at 0.78, just off its tightest level of the year (see chart 4).

Chart 4

With a few bumps along the way, the proportion of loans trading at distressed levels fell consistently in 2023, reaching 19.4 at year end, down from 27.7 when the year began and marking the tightest level of the year.

Additionally, the proportion of distressed EUR first lien loans fell sharply in 2023 after beginning the year at 25.9. The EUR first lien distress ratio failed to regain its October low, but finished the year more than 14 points tighter at 11.5. Sample size is partly responsible for the sharp drop, with a much smaller number of EUR first lien loans in sample than that for USD (438 vs. 1,417 as of Jan. 19). Levels of distressed USD first liens also improved, falling to 16.9 at year end, down from 22.9 when the year began and its tightest level of the year.

Chart 5

Broad-based Support For Loans Continues In 2024 Amid Improved Sentiment

Since November, the bid on loans has benefited from both a shift in market expectations around the path of benchmark rates and growing optimism around credit resilience. Improvements in market sentiment have been warranted, but we continue to see the balance of risks tilted to the downside, with room for volatility to return to the secondary markets in 2024.

Optimism has continued to bolster the bid on loans throughout the first few weeks of this year. Over the trailing four weeks, the average bid on all loans rose 0.3% to 98.77, with 94% of loan sectors seeing higher average bids. Better-than-expected demand-side data, further easing in core inflation, and loosening credit conditions all could underpin a higher bid on loans over the next 12 months (see chart 6).

Chart 6

Improved sentiment across secondary markets appears warranted, but the potential for credit risk to grow over the next 12 months also warrants market participants' caution as debt maturities pick up through 2025, and credit conditions remain tighter than they have been in more than a decade. The near-term outlook--defined by high inflation and higher-for-longer interest rates combined with low growth--could pressure the bid on loans and see the U.S. leveraged loan default rate climb to 3% by September 2024 (see "The U.S. Leveraged Loan Default Rate Could Climb To 3% By September 2024 As Economic Growth Slows", Dec. 19, 2023).

In the current macro-credit environment, we believe market liquidity remains a key risk to monitor over the next 12 months. In the trailing four weeks to date, the proportion of distressed loans has fallen 181 basis points (to 17.8). The reduction in distressed credits is a positive indicator for near-term market liquidity but bid depth and bid/ask spreads are little changed so far this year. As of Jan. 19, all loans had an average depth of 6.3 and an average bid/ask spread of 0.79 (see charts 7 and 8).

Chart 7

Chart 8