Loan Market to Cool Down as Summer Ends
June 25, 2009
The leveraged loan market’s mood at the half-year mark is warmer than it was at the end of 2008, but market participants nevertheless expect coolness to set in once again as summer ends and fall approaches.
“The leveraged loan market which was completely frozen at the end of 2008 has begun to thaw,” said William Welnhofer, a managing director in Robert W. Baird’s investment banking division. “But, while conditions have improved significantly over the last three or four months, we have a very long way to go to get back to where things were a year ago much less two years ago in the credit markets.”
Compared to the second half of 2008, of course, the first half of this year was booming. Year-to-date returns on the Standard & Poor’s/Loan Syndications and Trading Association Leveraged Loan 100 index topped more than 30%. That erased the -28% return seen in 2008. Average overall secondary loan prices have increased too, with one market barometer, Markit’s LCDX index, climbing out of the low 70s range and reaching into the upper 80s. After months of outflows, loan-focused mutual funds saw more action. Last week`, these funds saw inflows of $137 million in one week alone, according to AMG Data Services.
Yet market players are cautious, and according to David Frey, a partner at Stanfield Capital Partners, a New York-based asset manager focused on noninvestment grade loans, “investors should not get lulled into complacency by the price gains of the prior few months.”
Indeed, the market still faces significant challenges and volatility will likely continue, Frey said, which means that continued discipline and prudence are imperative. “The challenges are particularly acute for highly leveraged borrowers. That is because continued weak economic conditions lead to further leverage creep and strained liquidity. And with credit availability still constrained, default risk remains high and recoveries remain well below historical norms,” he said.
The recovery ratings assigned to U.S. leveraged loans dropped dramatically during the first quarter of 2009, according to Fitch Ratings. The number of RR1-rated loans—the highest recovery rating assigned by Fitch to a loan—dropped by 10% compared to the first quarter of 2008, while the number of RR6-rated loans—the lowest recovery rating—increased by almost 7% over the same time.
Besides deteriorating fundamentals, such as recovery ratings, the biggest concern among market participants is the lack of new issues on the primary market, which is evident from the volume of new loans on Thomson Reuters’ league tables (see chart below). Between January 1 and around the end of June, the top 25 firms issued $47.9 billion in new loans, almost $180 billion less than what they issued in the first half of 2008. And many of those loans came in the form of debtor-in-possessions, asset-backed revolvers and amendments (see chart below).
“We are going to see more of the same, with self-help deals like amendments and bond-for-loan takeouts, and not much new in terms of M&A,” an analyst said.
It’s not just the buyside that has been hurt by the lack of new issuance: Sellside participants have seen their fees that come from leveraged loans dry up over 2009. As of May 31, U.S. loans have averaged just 9% of a bank’s fee pool, according to Dealogic. In 2007 and 2008 loans made up 20% and 17%, respectively.
Thinner fees are indicative of a market that is in the process of downsizing, sources said. “[The loan market] continues to shrink down to size. I think this will continue as more and more collateralized loan obligations fall out of compliance or hit the end of their reinvestment period,” said a Connecticut-based investor. “Fewer buyers equal a smaller market.”
On a more macro level, many are concerned about rising inflation in the second half of 2009. Given the high level of capital raised by the government and the cost of future projects, such as health care reform, higher inflation is perhaps inevitable, but loan market participants are not so spooked by it—not yet, anyway.
“At this point inflation is more of a theoretical threat than an actual threat, said Welnhofer. “Clearly, the Fed is on a very thin tightrope, trying to stimulate the economy without stoking inflation.”
Randy Schwimmer, a senior managing director and head of capital markets at Churchill Financial, added, “It’s hard to see a lot of inflationary pressure out there. People who are worried about inflation are looking beyond the numbers.”
Loan investors seem to be more concerned with falling Libor rates and opportunities on the secondary. “Loan investors are attracted the 10% to 12% yields on the primary high yield bond market because Libor has come down significantly and new loans have Libor floors on them,” a New York-based loan investor said. As of June 24, the three-month Libor rate, which is set by the British Bankers Association, stood at 0.61%. This time last year the rate was around 2.81%.
Overall, however, despite the challenges they faced, the credit markets outperformed the expectations many had at the start of the year, sources said. However, the remaining challenges give investors plenty of reason to be cautious.
“We think it’s still too early to be aggressive, and given the recent run-up in prices, we remain cautious on the loan market in the near term,” said Frey.
While confidence in the second half of 2009 remains low, investors don’t see the market hitting the lows it reached in the second half of 2008. “There’s not a ton of confidence in the markets for the second half of the year; everyone’s trying to muddle along,” said Schwimmer. “But in this environment, as someone reminded me today, muddling along is a positive outcome.”
For more information on related topics, visit the following:
