Leveraged Loan Market Feels The Love

Leveraged loan investors are blushing. And it's not from a kiss on Valentines Day.

For the first seven weeks of 2009, the leveraged loan market gave investors some much-needed loving. Year-to-date returns are between 8% and 8.5%. For the week ended Feb. 4, inflows into loan mutual funds climbed to $135 million, the largest weekly inflow since July 2007, according to AMG. And on Feb. 9, the Standard & Poor's/Loan Syndications and Trading Association leveraged loan index was up 7.4% for the year.

Even the CLO market saw some activity. Fraser Sullivan Investment Management managed to launch a $262 million CLO, ending a near five-month drought.

"For the first half of January we had zero new deals. Two weeks ago, we got seven," said a New York-based investor. "These are new midmarket LBOs with term loans. These deals show we are seeing some signs of life."

The loan market also got a shot in the arm from a number of debt repayments, which soared to an 18-month high of $17 billion by the end of January. Loan repayments equaled only $3.4 billion in December. These repayments include debt for Alltel and INVISTA, which paid off its $980 million term loan B at par, handing investors a 20-point return. These repayments helped keep the rally going by putting cash in investors' hands. And with so many companies paying back their debt, total outstanding loans contracted in January by $15.7 billion or 2.64%, the largest decline on record, according to S&P Leveraged Commentary & Data. The prior record was $4.7 billion in December 2007.

Another plus came from a decrease in the number of BWICs-bids wanted in competition. There were roughly $476 million in BWICs last month, down from a fourth-quarter monthly average of $1.9 billion.

Furthermore, AMG reported that loan mutual funds took in $177 million in January, the first month of net inflows since June. In the last six months of 2008, the average monthly withdrawal was $589 million.

This demand is coming from two sources: crossover high yield investors and institutional investors. High yield bond funds have also received strong inflows, with AMG reporting $2.8 billion flowing into these funds from Jan. 1 to Feb. 9. That is the best start to any year since 2001, and that money is spilling over into loans. During the same period last year, investors pulled $674 million from high yield mutual funds, and inflows for all of 2008 equaled only $2.1 billion. As for institutional investors, such as pension funds, endowments and equity hedge funds, they have been frustrated with low yields on U.S. Treasuries, sources said.

All of this is set against a backdrop that is scarce of large new issues. Excluding debtor-in-possession loans, banks have shopped just two large-cap deals so far this year-a $354 million exit facility for Interstate Bakeries and a $225 million second-lien term loan for Rite Aid. The reason the primary market remains quiet is because CLOs are using what cash they have to fix their triple-C buckets, sources said. CLO managers are restricted from holding too much triple-C-rated debt, and because of the economic downturn, many of these buckets are overflowing. To remedy this, CLO managers have to sell the triple-C-rated loans for less than what they bought them for and buy higher-quality paper. So despite the Fraser Sullivan CLO, the CLO market, sources said, will remain frozen for the near term.

Moreover, companies today are faced with a choice of issuing loans with costly yields-spreads of as much as 15 to 20 points-or with a long non-call period. High yield bonds, by contrast, do not require amortization, maintenance tests or collateral. Furthermore, companies can issue bonds without repaying existing first-lien loans.

The primary loan market, investors said, will not see much activity until average secondary prices climb back up into the 80s. And that will not be for a while.

This rally, in fact, could be a fluke, portfolio managers said. "I'm not sure why it continues to rally," said a Canadian investor. "The market has over-rallied at this point. It seems to be ignoring economic news. I actually want it to go back down; I'd like to see some more buying opportunities."

While investors question the longevity of this rally, what is more important to them is whether or not this rally denotes a market bottom. "I think everyone is still trying to figure out if this is the bottom and if December marked a turning point where things won't get any worse," said the New York-based investor. "I think things have stabilized."

Neal Schweitzer, a senior vice president with Moody's Investors Service, added, "While the loan market may not be back, the primary high yield bond market is reviving. Yes, it might take a bit longer for the loan market to regain strength, but high yield investors are showing a renewed interest for decent speculative-grade companies. And if there is interest in high yield debt, there should be little distinction between asset classes. However, high yield investors are not banks, and the loan market is still being held hostage by capital constrained banks." -RK

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