2010: The Good, the Bad and Hopefully Not Ugly
December 29, 2009
As is often the case when looking into the future, we have some good news and some bad news regarding the leveraged loan market in 2010. The bad news, though hardly a surprise, comes in the form of returns—much lower ones. The good news is the expectation that primary issuance will continue to increase, with some market participants portending the return of the CLO.
“Everything I’m hearing leads me to believe that I will be very busy in the primary market,” said a loan trader. “I can’t really put a finger on expected volume at this point, but suffice to say, it should be active.”
Bank analysts estimate U.S. institutional loan volume will hit somewhere between $70 billion and $100 billion in 2010, a significant increase from 2009’s syndicated loan volume, which was somewhere around $20 billion to $30 billion depending on who you ask. Indeed, the institutional loan market saw only a fraction of all debt underwritten by banks.
The majority of 2010 proceeds will be used by companies looking to refinance debt and make acquisitions, market participants say. However, the new issuance market could see a lot of activity from companies coming out of bankruptcy with large exit facilities.
“I think amendments will continue at a rapid pace and that there will be more M&A activity,” said a New York-based investor. “Overall, I think there are plenty of signs pointing to higher overall issuance levels relative to 2009.”
However, lender liquidity remains a big concern, sources say. “With the consolidation in the banking industry and a cautious lending environment, it’s particularly difficult to complete the syndicate for large, widely held deals,” said Jeffrey L. Dunetz, a partner in Mayer Brown’s finance division, who heads the ABL practice in the U.S. “As a consequence, many deals are being completed with the lead arrangers holding a disproportionate share of the loan, with the smaller lenders filling out the syndicate.”
But who is going to buy these new loans? Market participants say the loan market will continue to see an uptick in the level of inflows into loan funds. Analysts at Bank of America estimate that loan funds will see inflows amounting to $31 billion in 2010.
“The retail loan market is still underserved and provides a way for managers to diversify away from hard-to-find institutional money,” said a New England-based loan investor. “I wouldn’t be surprised to see at least three or four new loan funds launch in 2010.”
The Bank of America analysts also expect to see roughly $15 billion in new money flowing into CLOs. “There is a good chance of seeing the CLO primary re-emerge in the future,” said the analysts. “Its new form is likely to be different from former structures, particularly with respect to leverage.”
In 2009, several encouraging signs began to emerge from the CLO market. A couple of new deals were done late in the year, while metrics, such as OC tests, improved for a number of CLO managers.
Analysts at Wells Fargo believe there could be between $3 billion and $6 billion in new CLOs in 2010, while analysts at JPMorgan think that number will be around $5 billion.
“There is a considerable amount of talk in the market regarding potential for new CLO issuance,” said Michael Khankin, the director of structured credit portfolio management at NewOak Capital. “Clearly CLO managers, bankers, traders, current CLO investors, and, less directly, the loan issuers themselves want to see this market recover.”
Wells Fargo grabbed the market’s attention right before Christmas by pricing a $275 million CLO that focuses on loans made to midmarket companies.
“That deal was static and short—a balance sheet financing for a player with limited direct access to the capital markets,” said Khankin. “So are new CLOs wishful thinking? Given the massive rally in loan prices this year, with many loans trading in the 80s and 90s, yields are not significantly wider than the secondary AAA CLO spreads, making such financing uneconomical. And unless you have some really cheap loans, the CLO liabilities are generally trading at a discount to the portfolio after taking fees and expenses into account. So until AAA spreads come in another 100 to 200 bps relative to loans, we shouldn’t expect to see a deluge of issuance.”
Yet some market participants say the CLO market has some secret gadgets under its hood. “I wouldn’t be surprised if we see a private market develop for CLOs, where someone has some equity and finds a big lender or provider of the triple-A-rated paper and they strike a deal on their own,” said an analyst at an industry trade group. “These structures will include many of the indentures you find in CLOs today—WARF tests, interest coverage tests, etc.—but it will be done on a privately negotiated basis and perhaps without the involvement of the rating agencies.”
Can’t Get No Higher
As for the bad news about returns, that comes after a record year impossible to duplicate.
The total return on the Standard & Poor’s/Loan Syndications and Trading Association U.S Leveraged Loan 100 index, which tracks the 100 largest dollar-denominated first-lien leveraged loans, is slated to end the year slightly above 50%. Not only was the buy side happy, so was the sell side. For bankers receiving fees from high yield bonds and loans, 2009 was the second best year on record. Returns though for 2010 are expected to be far more modest. Analysts at Barclays and Citigroup forecast leverage loan returns between 7% and 9%.
“But before anyone starts complaining about the more restrained call for loans, it is important to remember high single-digit returns [suggest] a rather strong year,” a Citigroup analyst noted in a recent report.
Loans were able to generate such high returns in 2009 because prices began the year in an unprecedented trough, following the collapse of Lehman Brothers in the fall of 2008. As the market corrected, secondary prices climbed from the lowest levels ever up into the low- to mid-90s. And in the meantime, any new loans hitting the market were forced to carry a significant discount to compete. “Looking back, it’s nothing short of a miracle to be where we are now,” the industry trade group analyst noted.
Loan market participants said they still expect to see deals with Libor floors, discounts and other incentives. Moreover, lower-priced LBO loans that have sponsor support, as well as the potential to improve the company’s credit profile; distressed or defaulted loans that have turnaround or reorganization potential; and second-lien term loans for healthy credits with substantial coupons all have the potential to give investors double-digit returns in 2010, according to the analysts at Barclays.
The Citigroup analysts added, “Over the course of 2010, we probably will see the lower end of the credit spectrum deliver superior returns, but it might not be as straightforward as last year’s technical suggests.” Triple-C-rated loans in 2009 returned more than 100%, according to Citi. This, however, may not continue into 2010 because investors might unwind their triple-C investments. And that would put pressure on loans in that rating category. The Citi analysts believe single-B-rated loans have a better opportunity to perform well in the early part of 2010.
Another factor that might help loan investors boost returns: Libor. According to Barclays’ estimates, Libor rates, which fell from around 1.5% at the end of December 2008 to 0.25% at the end of 2009, will be around 0.5% in 2010. This will likely to happen because of a Federal Reserve interest rate hike. And it will likely boost coupons as a result, an analyst said.
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