Lev Finance Market Awaits New Players

According to the wisdom of Bud Abbott and Lou Costello, What is on second base (Who's on first and I Don't Know is playing third; Tomorrow is pitching). With trading levels thin and prices extremely low, market observers are right to ask: Who's investing in the secondary? Sellers are seeing few buyers suiting up to play right now, but market participants expect a full roster of equity investors, hedge funds and private equity-backed players batting for yield this year.

"You do have this pool of capital that's starting to flow from many different places," said Thomas Huggins, a portfolio manager with Eaton Vance. He added that it makes sense for different kinds of investors to be moving into high yield bonds and leveraged loans, since yields are so high now.

Chief among the new funds entering the scene are equity and combination equity and debt funds. "We're hearing about more equity funds that have the ability to move back and forth, like balanced funds, between bonds and equities," said Huggins. "There are a lot of inquiries now, especially in last four to six weeks, from guys who have been out of the high yield market for a while and are interested in product. ... They might be financial advisors or endowments or institutions or high net worth individuals. ... We're getting a lot of those calls now, and the phone hadn't been ringing the first 10 or 11 months of the year."

Yields & Defaults: A Not-So-Gay Marriage

Leveraged loan investors stand to gain yields of as much as 20% per year by buying discounted loans, according to a study released by DBRS. With loans from well-performing companies trading as low as 66 cents on the dollar, secondary buyers can get an extra 10% to 15% yield on a loan, depending on its maturity date. That combined with the original yield, which is typically between 5% and 6% on loans priced over the last two years, can bring the yield up to 20%. High yield bonds are, on average, trading lower than leveraged loans, making their potential yields even greater.

The study notes, however, that upward-trending default rates could cause investors to lose as much as 10% of their portfolio in a single year or every year for two or three years in a row, though the study notes that this scenario is "draconian."

"A lot of people are looking at the equity market, and the equity market is pricing for a recession. But the bond market is pricing for a depression," said Matt Eagan, vice president and portfolio manager with Loomis Sayles. "It looks like there's less downside risk in buying assets that are already pricing that in."

Huggins points out that many of the equity investors may be investing in bonds and loans for companies they invested in as public companies before they were privatized via LBO. Since these investors know the company well, and the loans and bonds stand to earn higher yields than many stocks, it makes sense for them to make the switch.

Another source of buying in the leveraged loan and high yield secondary markets has been private equity-backed groups. "There's definitely been some private equity buying here," said the head of high yield trading at a New York-based firm. "There are funds that are marketing under whatever name they want to call themselves, but you know it's backed by private equity money."

Private equity firms have also been making additional inroads in more open ways, as debt returns promise to be good and traditional buyout opportunities dried up together with easy credit. "We do clearly know that private equity is in the market buying because they're doing everything from setting up funds to do that themselves-some private equity shops have described themselves as bond shops-to buying debt in deals they LBO'd less than a year ago," said Huggins. Some are buying debt in portfolio companies, others are buying debt in companies that they bid on unsuccessfully during the boom period and taking advantage of the distressed prices of those companies' bonds and loans. Should the companies go bankrupt, these new debt holders will be in a superior position in the capital structure and have an ownership stake in the company.

Some observers note that many private equity firms gravitated towards the leveraged loan market in the earlier part of 2008, when loans were trading in the 80s. Some may be above their allocation in loans now, and others were burned when the market traded down another 20 points.

Companies also continue to buy back their own debt, taking advantage of the low prices on bonds and loans and hoping to prepare for a wave of maturities that will hit the market this year and next.

Still Sitting On The Sidelines