William Maxwell - Leveraged Financial Markets

A COMPREHENSIVE GUIDE TO HIGH-YIELD BONDS, LOANS, AND OTHER INSTRUMENTS

WILLIAM F. MAXWELL
MARK R. SHENKMAN

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William F. Maxwell

William F. Maxwell

William F. Maxwell, and
Philip Delbridge

Daniel Toscano

Frederic R. Bernhard, CFA (SCM)
John E. Kim (DB), and
Jonathan A. Savas (SCM)

Jonathan Blau

Amy Levine, CFA, and
Nicholas Sarchese, CFA

William J. Whelan, III

William F. Maxwell, and
Philip Delbridge

William F. Maxwell, and
Philip Delbridge

Mark R. Shenkman

Mark R. Shenkman

Frederic R. Bernhard, CFA (SCM)

Neil Yaris, and
Jason Hodes

Sivan Mahadevan,
Morgan Stanley,
Peter Polansky, and
Morgan Stanley

Vishwanath Tirupattu,
Sivan Mahadevan,
Peter Polansky, and
Morgan Stanley

William F. Maxwell, and
Philip Delbridge

David J. Breazzano

William F. Maxwell

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

Broadly defined, leveraged finance deals with the riskiest forms of debt financing. These encompass original issue debt from investment-bank-issued debt, high-yield bonds, or bank-issued debt (leveraged loans), and debt that has fallen from investment grade to high-yield status (fallen angels). Credit default swaps also play an important role in these markets because they are derivative contracts deriving their value from the risk of default on specific firm debt or aggregate default risk. As such, they provide an alternative mechanism for investors to take short or long positions on the underlying assets.

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

The leveraged finance market has always been a volatile market, with the market experiencing significant boom and bust periods. It is not surprising then that the leveraged finance market as well as all aspects of the financial market experienced dramatic upheaval during 2008. In 2008, the high-yield bond, leveraged loan, and credit default swap (CDS) indexes were down by 27%, 29%, and 13%, respectively. However, the high-yield bond and leveraged loan markets recovered with historically high returns of 50% in 2009. In addition, 2009 was a record year for high-yield bond issuance, but it also evolved back closer to its roots with the virtual disappearance of leveraged loans. Even after the financial market meltdown in 2008, it is clear that leveraged finance remains one of the cornerstones of financial markets.

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

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