Loans take the strain in 2022 - but for how long?

The dearth of corporate issuance points to the generally healthy state of corporate balance sheets following the pandemic. Years of stimulatory monetary policy, easy liquidity and – in many sectors – positive consumer sentiment have left borrowers cashed up and able to wait for certainty in markets. But year-to-date syndicated loan volume also demonstrates a shift in market choice.

Borrowers have clearly taken advantage of favourable conditions to fund via syndicated loans. Following a record 2021 that saw nearly US$120 billion equivalent of syndicated loan volume for Australian borrowers, volume for H1 2022 was up by a further 30 per cent over the prior corresponding period, according to Refinitiv data.

Tim Steven, head of leveraged and syndicated finance at RBC Capital Markets in Sydney, tells KangaNews volatility in capital markets has created an opportunity for the loan market as pricing in the latter typically responds more slowly to negative inputs and thus becomes the obvious source of funds for borrowers.

Gavin Chappell, Sydney-based head of loan syndications at ANZ, adds: “The bond market offered pricing inside the loan market at the end of last year and as a result we lost some market share as borrowers went to bond issuance. Now it is the reverse, with loans being executed more cheaply than bonds. It is always swings and roundabouts, and the bond market will catch up – but at the moment the gap is too big.”

Liquidity is as important as pricing, and bank sources emphasise that loan deals have continued to print throughout 2022’s volatility because investors are still eager to lend.

“While the market is not immune to volatility in international capital markets, we are seeing continued demand for quality borrowers and transactions in the corporate and acquisition financing market, and we expect appetite to continue for the right deals with structures and pricing that are appropriate to current conditions,” Steven says.

There are further factors at play, too. In an uncertain rates environment, Chappell says, corporate borrowers typically favour the floating-rate funding offered by loans. Meanwhile, growing focus on sustainability-linked loans (SLLs) (see box), which also saw record volume in 2021, has supported loan momentum – especially as sustainability-linked bonds are even more challenging to issue.

The primary reason why corporate borrowers have tended to favour loan funding over bond markets – domestic and global – in 2022 is, loan bankers agree, that loan margins have not repriced to anything like the same extent as capital markets. However, the reason why suggests the differential probably will not last forever.

Banks’ cost of funds models vary, which means credit margin volatility and increasing baseline yield can affect loan pricing more slowly than they do bond pricing. For instance, Chappell points out that many Asian banks in particular are very heavily deposit funded. They are therefore even less exposed to wholesale debt market pricing than their Australian peers, which top up substantial deposit bases with a significant ongoing draw on the wholesale bond market.

But market users agree the lag is temporary. Ultimately, banks will have to pass their own increased funding costs through to their customers and, as central banks reach terminal rates and markets settle, loan and bond market pricing should move closer together.

It is certainly not as simple as a straight line from bank wholesale funding cost – which has increased across the board – and the pricing banks offer on syndicated lending. The deposit market has yet to reprice in line with bond markets, offering many banks a cheaper funding base than the wholesale market alone would imply. This is likely to change at some stage but may not yet be imminent.

Even so, signs are that loan margins are starting to tick upwards even if they are still highly competitive. James Poulos, head of loan markets and syndications, Australia and New Zealand at MUFG Securities in Sydney, explains that lending costs depend on a number of factors, with each bank affected differently depending on how it sources its capital. He says liquidity in the loan market remains robust and he does not expect availability of funds to have a meaningful impact on volume as a standalone factor – because lender liquidity for loans should remain resilient.

“We expect increased funding costs will be reflected in higher loan margins, although liquidity should remain strong as a number of market participants, on- and offshore, remain focused on building their Australian loan portfolios,” Poulos adds. “While refinancing tasks will continue to underpin market activity, volume will also be strengthened by ongoing M&A flow and a healthy project finance pipeline that will require bank finance over the coming 6-18 months.”

Tim Bates, head of loan syndicate at Commonwealth Bank of Australia (CBA) in Sydney, agrees that the pricing gap between bonds and loans will decrease over time and equilibrium will emerge. But he does not expect this to happen for as long as volatility remains the watchword – adding that it is hard to see the landing point at this stage.

Bates also notes that impending higher bank funding costs may have further juiced volume as corporate borrowers seek to get ahead of the expected flow of cost into loan margins. “We have seen ongoing overall appetite in the loan market and we expect it to continue as the market remains open throughout volatile periods,” he says.

Getting ahead of an anticipated pricing trend is not the only reason for a bulge in loan volume, even before the relative cost of loan versus bond funding is factored in. Market users say M&A activity has also been a major factor behind loan volume – and they recognise that the changing macroeconomic backdrop may have a dampening impact on M&A even as the near-term pipeline remains solid. This would affect volume even if pricing and liquidity mean bank funding continues to offer a reliable way of financing deals.

Steven comments: “M&A volume should be the key driver of loan market activity for the remainder of 2022. But corporates, sponsors and credit investors are likely to be more selective on transactions they pursue and focused on appropriately structured and priced transactions.”

Even if M&A activity eases, market users expect the loan market will continue to attract more than its fair share of refinancing activity. If, as many suspect, rate rises spark an economic downturn, the worst they expect is that lenders will apply greater scrutiny to transactions and heighten their focus on borrowers’ sector and credit quality.

Bates says: “Banks are still keen to lend and, especially, to support core relationships – there is still broad-based appetite in the market. We have not seen a big pullback in appetite or banks seeking to leave the market in the same way as we did in previous cycles. This said, we anticipate some degree of natural flight to quality.”

Assuming loans are priced to market, Poulos expects liquidity will remain strong, particularly as more investors look to the Australian market to deploy capital – in some instances expanding their lending remits. “We have yet to see any material reduction in lending appetite from our investor clients, although there is a closer focus on ensuring loan margins meet internal benchmark requirements,” he comments.

One factor that might change the makeup of Australian corporate borrowing is the desire for funding diversification. While bank liquidity has held up well even as central bank tightening has started to bite, corporate borrowers learned the hard way in the financial crisis that relying on a single source of debt funding can prove costly. Even if syndicated loans continue to present better upfront pricing, borrowers may choose to pay up – at least to some extent – for bond deals simply to ensure their access to capital markets does not dissipate.

Chappell says the loan market remains the most used backstop source of funds – the place borrowers will go if loan pricing or liquidity are unpalatable. But while he adds that there is “certainly plenty of liquidity in the loan market” to accommodate a solid pipeline of refinancings, he thinks the outlook ultimately depends on just how much loan liquidity borrowers will add before feeling the need to tap other funding sources.

Sean Sykes, Sydney-based head of loan markets origination at CBA, predicts volatility will be the dominant theme for markets in the immediate future but says the syndicated loan market’s ability to function throughout volatile periods will help keep deal flow stable. He also foresees a “natural flight to quality” in banks’ allocation of capital, favouring defensive noncyclical companies over higher-risk transactions.

“We are emerging from a very long, very benign period of low volatility,” Sykes says. “Our messaging to clients is holistic – we are looking at all their treasury-related risks, not just funding and not just the mix of loans versus bonds. It is also about understanding funding risk and being proactive in the strategies borrowers employ to stay on top of those risks.”

The ongoing positive environment for loan issuance has also helped foster the market’s evolution, with more lenders now participating and a notable step up in the range of products available.

“Domestically, we are seeing more institutional term loans – in which borrowers are able to get longer tenor,” Bates says. “We have seen new participants seeking to get involved in these deals, which means not just banks but life insurers and super funds as well. While it is still a relatively small portion of the overall loan market, it adds to the liquidity picture as we seek new ways to assist corporate Australia to meet its funding objectives.”

A recent trend has seen more offshore banks setting up branches in Australia, supporting liquidity in the loan market and therefore its stability. According to Sykes, the volatility prevailing in markets today would have caused the offshore bid to retreat five years ago, whereas many more banks now have a permanent presence in Australia.

“The fact that offshore banks are establishing teams here adds credence to the claim that they want the client base to see them as consistent through all cycles. Having this reputation is an important element of credibility for arrangers,” Sykes says.

Critically, market participants all describe the current landscape and outlook for syndicated loan funding as different from the circumstances of the global financial crisis, which sparked an evaporation of liquidity for bank lending and capital markets alike.

Chappell explains: “What we are experiencing is not a liquidity crunch – it is just a question of price for liquidity. Deals can still be done in the bond market if borrowers are willing to pay the price – they just do not want or need to. These are not the same dynamics that were at play in the financial crisis, when many borrowers simply could not get deals done.”