Unwinds, Write-Downs And Weirdness, Oh My

February 18, 2008

Dorothy just wanted to go home, back to Kansas where life was in black and white. Instead, she got kidnapped by delinquent flying monkeys, force-fed poppy dust by a pusher witch (with an irrational hatred of dogs) and finally arrived in Oz to be dissed by the wizard, a big fake who told her she could have gotten the hell out of there ages ago.

All in all, Dorothy might feel a bit of deja vu in today's leveraged finance markets, where everything has gone all wicked and weird and more than a little bit off.

CLOs, which up until six months ago made up such a large portion of the leveraged loan investor base, face a new round of liquidations. The word is that some have begun to unwind, while other funds struggle to find alternatives, as our front page story by Richard Kellerhals shows.

And largely thanks to the sinking Libor rate, we have bond funds outperforming loan funds, a phenomenon the market hasn't witnessed in years, as Matthew Sheahan writes in another of our front page features. The year-to-date cumulative total return for floating-rate funds is at -4.66%, versus -2.68% for junk bond funds, according to Lipper.

Moreover, analysts predict more write-downs for investment banks this quarter (which probably has bankers wishing they could get their hands on a little poppy dust right about now).

"Even though exposures stand at smaller levels, the larger [loan] price declines and lack of offsetting fee income imply larger potential write-downs than during Q3 of last year," Bank of America analysts wrote in a recent report.

All of which might lead market participants to wish for the good ol' black-and-white days of Kansas, or to hope that one day they'll wake up to find it was all a peculiar dream. Unfortunately, clicking the heels of one's ruby slippers is not an option in the credit markets.

Besides, things may feel all topsy-turvy right now, but that's where the opportunities begin. Indeed, analysts already note interest from experienced loan investors, as well as nontraditional players.

"There's no reason you couldn't trade through recoveries," one bank strategist said. "You just have to get to valuations where you draw enough interest from nontraditional players."

When that happens, plenty of strong companies with underpriced debt will be waiting. And eventually, we'll arrive again at the emerald city, maybe a little less ostentatious than the buyout boom version, but green nonetheless.

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