Refinancing Cliff

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Leveraged Finance U.S. Special Report
Analysts
Darin Schmalz +1 312 606-2324
[email protected]

Bridging the Refinancing Cliff
Executive Summary
Fitch has evaluated the potential gap between the supply and demand for leveraged loans over the next five years, and concluded that the imbalance is much smaller than the absolute debt maturities imply. Key observations and findings include:  While recent refinancing activity has diminished a substantial portion of the debt coming due over the next two years, this activity has not eased the pressure created by the $600 billion of leveraged loans expected to mature between 2012 and 2014. Various refinancing sources will likely be strained over the next several years. However, amend and extend agreements (A&Es), bond-for-loan takeouts, increased capacity within the leveraged loan market (including a revival of the collateralized loan obligations [CLO] market), asset-based lenders from the non-syndicate loan market could reemerge to supply some loan volume and pre-payments (both mandatory and voluntary) are likely to absorb much of the demand for refinancing during this period. In particular, Fitch expects A&E volumes to continue to increase through 2014, allowing the market to redistribute loan maturities to a level more easily absorbed by traditional market sources. Also, the demand for capital could be a catalyst for renewed CLO activity in the coming years. This CLO activity could contribute meaningfully to the supply of credit available for refinancing Based on historical leveraged loan and high yield bond activity overlaid with moderate forward-looking assumptions, a gap between the supply of and demand for credit will exist from 20102014. Fitch estimates this gap will total between $50 billion and $100 billion. There are a number of material (and intertwined) swing factors to Fitch’s estimates. First, the degree of economic stability and associated risk of a double-dip recession will influence the size of the supply/demand mismatch. Second, the trajectory of the equity market and associated expansion/compression of valuations could affect the willingness of lenders and the equity markets to provide capital for refinancing.
Debt Maturity Profile
Leveraged Loans ($ Bil.) 250 200 150 100 50 0 2010 2011 2012 2013 2014 2015 2016 Source: Thomson Reuters, Merrill Lynch Master II Index. High Yield Bonds

Mike Simonton, CFA +1 312 368-3138
[email protected]

Elizabeth Nugent +1 212 908-0157
[email protected]



Related Research
 Top-Heavy Debt Structures: Secured Debt Weighting Grows, but Flexibility Remains, Feb. 18, 2010  Speculative-Grade Credit Quality Showing Signs of Stability, Feb. 11, 2010  U.S. Leveraged Finance Quarterly Review (Fourth Quarter and Full Year 2009), Feb. 4, 2010  U.S. High Yield Default and Recovery Rates 2009 Review and Outlook, Feb. 4, 2010  Liquidity and Covenant Analysis for Large Speculative-Grade Issuers, Jan. 19, 2010  U.S. Corporate Credit Commentary: The Long March Begins, Jan. 7, 2010  U.S. Structured Finance: 2010 Outlook, Dec. 8, 2009







www.fitchratings.com

March 22, 2010

Corporates
 Fitch believes that absent catastrophic adverse economic conditions (or a peak interest rate environment), the market is likely to find a clearing price and associated terms at which much of the demand for credit can be satisfied. In general, Fitch believes market forces will work to ease the pressure created by the refinancing cliff that otherwise could result in an unparalleled spike in loan default volume.

Bridging the Refinancing Cliff
At any point in time a majority of outstanding leveraged loans are expected to mature within seven years, and most high yield bonds are expected to mature within 10 years. Historically, the maturity profile of these asset classes has been relatively flat. This resulted in few funding problems in refinancing debt maturities or providing growth capital to leveraged borrowers. However, over the next five years, the leveraged loan market will be presented with an unprecedented concentration of debt maturities, much of which was funded initially by the now-dislocated CLO market. Specifically, nearly $770 billion of leveraged loan debt comes due during the next five years, which has created a significant overhang in the credit markets. The $770 billion of maturing loans represents almost 90% of the total amount of leveraged loan maturities through 2018. The chart below identifies the four sources that should meaningfully smooth the contour of the refinancing cliff. The potential capacity of the various sources is broken down in greater detail below.
Bridging the Refinancing Cliff
($ Bil.) 800 700 600 500 400 300 200 100 0 Leveraged Loan Maturities (2010–2014) Source: Fitch Ratings. Loan Refinancing A&E Agreements Bond-for-Loan Takeouts Mandatory Prepayments Other ($135) ($80) ($55) $75 $770 ($425)

Leveraged Loan Market Refinancing Capacity
Assuming 45% of total annual loan volume will be used to refinance loan maturities, and that leveraged loan issuance averages between $250 billion and $350 billion per year from 20102014, the leveraged loan market could potentially absorb approximately $425 billion of the refinancing cliff. This estimate is sensitized to account for the anticipated steady increase in the number of secondary CLOs entering their nonreinvestment periods through 2014, which will curtail their ability to participate in new loans or refinancing existing loans. This phenomenon is offset by a conservative assumption of modest new CLO issuance.

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Bridging the Refinancing Cliff

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Corporates
Leveraged Loan Refinancing Capacity
($ Bil.) Potential Total Lev. Loan Issuance 250 275 300 325 350 Portion of Total Lev. Loan Issuance Used For Refinancing 113 124 135 146 158 Net Lev. Loan Refinancing Capacitya 106 102 101 88 81

Year 2010 2011 2012 2013 2014 Total

Leveraged Loan Maturity Schedule 53 110 197 194 214

Impact on Refinancing Cliff (53) (102) (101) (88) (81) (425)

a Sensitized for lost refinancing capacity due to an increase in number of CLOs entering their non-reinvestment period, offset by new CLO issuance. Source: Fitch Ratings.

Fitch’s annual leveraged loan issuance estimates are consistent with issuance levels from 19982003, prior to the dramatic expansion of the structured finance market. While Fitch believes new and existing lenders will begin to re-enter the market and put money back to work, it will be a slow process. The floating rate nature of loans, in a potentially rising interest rate environment, could increase the supply of providers of loan capital. However, Fitch does not expect loan issuance levels will reach the magnitude seen from 20052007 over the next four years, given that the nature of CLO demand is likely to change. For example, due to the easy credit environment from 2005-2007, many middle-market borrowers that would have otherwise turned to the asset-based loan market for financing were able to receive financing in the cash flow loan market. Unlike most asset-based loans, cash flow loans were syndicated by the aid of CLOs. While it is likely that a sustainable CLO market would not include many of these marginal credits, it is possible that traditional asset based lenders will step back in to contribute capital to these entities. Further complicating the issue is the rapidly increasing number of CLOs entering their amortization period from 20102014. This will materially curtail the proceeds available to purchase new loans or refinance existing loans. Fitch estimates that CLOs today hold over 50% of all outstanding leveraged loans in the market. A potential funding problem arises in 20122014 when approximately $320 billion of institutional loans are expected to mature and will need to be refinanced  most of them held by CLOs. CLO issuance in the U.S. peaked in 2007, with approximately 30% of the current balance of outstanding U.S. CLOs originated in that year. Nearly 80% of current CLO outstandings, or approximately $200 billion, was issued over the course of 2005, 2006, and 2007. On average, CLO structures included a five-year reinvestment period, with some transactions extending to seven years during the peak of the market. Based on this assumption, amortization of CLOs originated during the peak of the market will accelerate in 2010 and meaningfully pick up pace through 2012. While the timing of amortization will depend largely on portfolio construction and the structure’s reinvestment terms, the U.S. loan market will lose approximately $225 billion in new funding capacity between 2010 and 2014. Primary CLO issuance may pick up in the second half of 2010 if transaction economics become attractive, partially offsetting the reduction in investment capacity of existing CLOs. Fitch expects only moderate growth in CLO issuance in the near term, with 2010 volume in the $3 billion to $5 billion range. In general, Fitch believes that the refinancing cliff could be a potential catalyst for new primary CLO issuance in the coming years, if both the economy and credit markets improve.

Bridging the Refinancing Cliff

March 22, 2010

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‘Amend and Extend’ Continuation
A&E volume reached $60.6 billion in 2009, according to Thomson Reuters. Assuming A&E volumes average $75 billion annually through 2014, Fitch believes that the refinancing cliff could be reduced by approximately $135 billion. This estimate was based on an average A&E maturity extension of approximately two years. Given this assumption, A&E agreements executed in 2013 and 2014 are likely to have the greatest impact on reducing the refinancing cliff by extending maturities beyond 2014. For the $75 billion figure to be reasonable, two assumptions would have to materialize. First, lenders would need to continue to support loan valuations through the execution of A&E agreements in exchange for covenant modifications and higher pricing. Lenders’ and owners’ incentives are generally aligned to avoid a large number of defaults. Most lenders are likely to arrange an A&E on favorable terms rather than endure a default or a difficult restructuring that could result in substantially lower loan recoveries. Secondly, A&E volumes should intensify if CLOs are permitted by their documents to participate in these agreements even while they enter their amortization periods. Given the concentration of a large volume of loan maturities among a small number of issuers, Fitch anticipates A&E volumes will likely exceed 2009 levels in the next couple of years. For example, seven companies alone have almost $100 billion coming due in 20132014. Companies such as TXU Corp., Ford Motor Co., First Data Corp., Chrysler Corp., HCA Inc., Univision Communications Inc. and Realogy Corp. could push out a substantial amount of maturing loans beyond the 2014 time frame through the execution of A&E agreements. However, this activity could be constrained as banks may be unwilling to provide debt that matures after the $500 billion of bond debt that comes due from 20142017. Complications arise when borrowers with loan maturities in the 20132014 time frame and bond maturities in the 20152017 time frame may be required by their banks to execute more comprehensive refinancing solutions that address their bond maturities and bank extensions simultaneously to ensure new bank debt expires before other debt.

High Yield Bond Market Refinancing Capacity
Assuming a relatively aggressive average annual high yield bond issuance of approximately $125 billion from 20102014, Fitch believes the high yield bond market could absorb almost $80 billion of the loan refinancing cliff.

High Yield Bond Refinancing Capacity
($ Bil.) Potential HY Bond Issuance 125 125 125 125 125 Proceeds Used for Bond Refinancing 23 47 58 77 125 330 Proceeds Used for Growth Financing 39 16 4 5 0 Proceeds Used for Other 38 38 38 38 0 Proceeds Used for Bond-Loan Takeouts 25 25 25 5 0 80

Year 2010 2011 2012 2013 2014 Total

Source: Merrill Lynch HY Master II Index, Fitch Ratings.

This high yield bond issuance assumption is based, in part, on the fact that annual high yield bond issuance has averaged approximately $110 billion over the past 10 years. Fitch notes that the high yield market has shown adequate capacity to absorb more than $150 billion of issuance in a given year (1998, 20032004, 2009); however, historical data

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Corporates
would suggest that these levels are not sustainable for long periods of time. Furthermore, issuance levels in excess of $130 billion in a given year tend to drop precipitously the following year. Fitch anticipates that future use of proceeds will be more diverse than in 2009, a year in which 75% of all high yield proceeds were used for refinancing. Fitch assumes approximately 50% of high yield bond proceeds will be used for refinancing bonds and growth financing from 20102014. This estimate takes into account the bond market’s current capacity to refinance approximately $330 billion of high yield bonds coming due during this period. Furthermore, Fitch assumes 30% of total new high bond issuance annually will be used for other corporate purposes, such as capital expenditures, acquisitions, and dividends. This is consistent with the high yield market’s historical average. Fitch concludes that approximately 20% of total high yield bond issuance proceeds could be targeted for leveraged loan refinancing annually.

Prepayments
Assuming that prepayments (mandatory and voluntary) reduce the outstanding leveraged loan balance by 7% per year, the refinancing cliff could be reduced by approximately $55 billion. The 7% figure is predicated on two assumptions. First, based on an analysis of FCF to secured debt for Fitch’s speculative grade portfolio, Fitch estimates that amortization, excess cash flow sweeps and voluntary prepayments could reduce the refinancing cliff by approximately 4% annually. Second, Fitch believes asset sales and equity sweeps could reduce the refinancing cliff by an additional 3%, which is consistent with historical averages. These estimates would prove conservative if a strong equity market during this time period resulted in (deleveraging) IPO exit strategies for a number of large LBOs. Higher valuation multiples could also enhance the willingness of lenders to provide capital that could be used for refinancing.

Other
The “Other” portion of the refinancing cliff represents the portion the market will need to absorb through an expansion of the aforementioned sources or by other means. In addition to macroeconomic conditions, default activity during this period is dependent on the degree to which these elements of credit supply (described above) materialize. If 5% of the amount coming due each year defaulted then defaults could account for $35 billion to $50 billion of the “Other” category.

Conclusion
The refinancing cliff from 20102014 might be far less precipitous than the absolute debt amount suggests. Markets have historically adapted to supply and demand mismatches with product introductions, unique market variations and adjustments to pricing and terms. Fitch believes that the longer-term portion of the refinancing cliff can be absorbed largely by a combination of A&E agreements, a slowly improving leveraged loan market and increased CLO activity, and an expanded high yield bond market. Each of these sources (as well as new product variations) are likely to flex somewhat to address the cliff such that defaults are not likely to exclusively bear the burden of the funding gap.

Bridging the Refinancing Cliff

March 22, 2010

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Appendix
Leveraged Loan Maturity Schedule:
($ Bil.)
Year Pro-Rata Loans Institutional Loans Total

2010 2011 2012 2013 2014 2015 2016
Source: Thomson Reuters.

44 82 131 112 43 12 3

9 27 65 82 171 56 26

53 110 197 194 214 68 29

Historical Data: Leveraged Loan Issuance
($ Bil.) Year 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Average Annual (19982009) Average Annual (Excluding Peak CLO Years) Refinancing 128 150 146 102 124 207 274 244 204 203 103 153 New Money 145 170 164 116 140 122 206 256 409 485 191 86 Total Lev. Issuance 273 320 310 218 265 329 480 501 612 688 294 239 377 281 Quarter/Month 1Q09 2Q09 3Q09 4Q09 Jan-10 Feb-10 LTM Feb-10 Total Lev. Issuance 33 72 50 85 20 31 282

LTM  Latest 12 months. Source: Thomson Reuters, Fitch Ratings.

Historical Data: Institutional Loan Issuance
($ Bil.) Year 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Average Annual (1998-2009) Average Annual (Excluding Peak CLO years) Refinancing 45 55 50 32 64 70 117 101 92 111 10 32 New Money Total Inst. Issuance 45 55 50 32 99 118 223 241 366 426 70 56 148 66 Quarter/Month 1Q09 2Q09 3Q09 4Q09 Jan-10 Feb-10 LTM Feb-10 Total Inst. Issuance 3 14 14 25 5 12 71

35 49 106 140 274 315 59 24

LTM  Latest 12 months. Source: Thomson Reuters, Fitch Ratings.

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March 22, 2010

Corporates
Historical Data: High Yield Bond Issuance
($ Bil.) Year 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Average Annual (19982009)
LTM  Latest 12 months. Source: Fitch Ratings.

Total HY Bond Issuance 151 100 47 95 68 152 158 93 131 136 41 152 110

Quarter/Month 1Q09 2Q09 3Q09 4Q09 Jan-10 Feb-10 2Q4Q Annualized 3Q4Q Annualized LTM Feb-10

Total HY Bond Issuance 12 52 39 48 15 14 186 174 170

High Yield Bond Maturity Schedule
($ Bil.) Year 2010 2011 2012 2013 2014 2015 2016
Source: Merrill Lynch HY Master II Index.

Total 23 47 58 77 125 133 125

Historical Data: ‘A&E’ Volumes
($ Bil.) Month Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Monthly Average LTM Dec-09 LTM Feb-10
LTM  Latest 12 months. Source: Thomson Reuters, Fitch Ratings.

Volume 0.0 0.0 2.7 0.9 5.0 15.2 4.5 6.9 3.5 4.7 11.7 5.7 2.6 9.0 5.2 60.6 72.2

Quarter 4Q08 1Q09 2Q09 3Q09 4Q09 2Q4Q Annualized 3Q4Q Annualized

Volume 8.2 2.7 21.0 14.9 22.0 71.8 77.2

Bridging the Refinancing Cliff

March 22, 2010

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Corporates

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Bridging the Refinancing Cliff

March 22, 2010

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