Bank loan volume to remain steady or rise in 2003, overall market seen better

By Sara Rosenberg

New York, Jan. 1 - Leveraged loan issuance in 2003 will either remain on a par with the past year's volume or increase, according to market professionals.

And they expect market performance in general to improve in the coming year.

Expectations for an increase in issuance in 2003 are based on various factors including a drop in the default rate, an increase in high-yield bond issuance and, most importantly, an improvement in the overall economy.

"I think you've got to think it's going up because the default rate is coming down and default rate expectations will help prop up the [robust] CLO market so there will be a lot of demand," a fund manager told Prospect News. "Plus the economy should be recovering and all those things together should mean that issuance goes up.

"And I think that goes hand-in-hand with the high-yield market too," the fund manager continued.

"If you look at the 10-year charts, bank loan issuance goes up with the high yield market and I think most people expect high yield issuance to be up next year."

The fund manager was not the only market professional to point to increased volume in high-yield bonds as leading to increased volume in bank loans.

"There has been certainly a rise in the high-yield bond market, which ought to be reflected in the leveraged loan market as well," said Steven Bavaria, director of bank loan ratings at Standard & Poor's.

"If you think that the economy is in fact really turning around, albeit slowly, then that should auger well for loan market activity. If the economy continues up we should see an increase in underlying activity that should result in both the high yield bond market and the leveraged loan market picking up.

"Some of the signs in the marketplace have been positive," Bavaria concluded.

However others are taking a more conservative stance, arguing that while issuance is not expected to taper off, it is not expected to increase dramatically either.

"Our outlook is that defaults have peaked and may subside a little bit but for the time being but they aren't going to decline significantly. There are still things to work through," explained Roger Arner, managing director at Moody's Investors Service.

"[Also], loan volume was reasonably high last year partly because of refinancing in the early part of the year and a little bit because of some M&A transactions later on in the third quarter and into the fourth quarter, but it clearly had tailed off a little bit. We're not looking for any sort of extraordinary growth next year.

"Particularly with M&A volume down, there are some deals getting done by financial sponsors but for the most part it's a somewhat quiet market," Arner continued.

"Having said that it seems as if the structured finance market and the CLO market has remained relatively strong, particularly in contrast to the CBO market, which has fallen out a bit. And the reason is the market has generally perceived loans to be less volatile. That's kind of a fairly generic view I think."

Higher Libor would help

If you agree with the view that the economy and bank loan volume will improve, then the outlook for bank loan market performance is a positive one for investors, issuers and syndication desks.

From an investor's perspective, if credit performance improves due to defaults having topped out and the underlying Libor rate rises in the year to come, then that certainly will be good news, according to Bavaria.

"[It] doesn't get worse than 2002 with incredibly low Libor and considerably high default rates and fairly low recoveries" the fund manager added.

"We're washing past telecom recovery, which really dragged down the averages a lot. Libor should go up and cover up the multitude of sins and basically if the economy is better the default rate will be down.

"So I think the performance of the bank loan market should be better in 2003.

"I mean one of the big interesting questions is that there's never been a negative year in bank loan performance and with one month to go both the Bank of America index and the CSFB index are marginally negative. With a solid month they might crawl into the positive territory and if they don't then all our sort of perfect records of positive performance will be out the window. So I sure hope we do better than that.

"The only fly in the ointment is that there are a lot more people now who feel the need to trade bank loans and bonds together as some sort of relative value play - even though not many people can play relative value. Nor is it necessarily intellectually correct to believe in relative value in the sense that even if the bond drops 20 points that doesn't mean that the odds of you not getting all your money back with interest on the bank loan may have changed at all.

"But the trading mentality out there says those two things must trade together so with increased volatility you have some chance that the bank loan market will continue to be affected by that.

"But in general, ignoring that extra wrinkle which affects all markets these days as more and more people look at volatility as a prime driver of things as opposed to a secondary effect, I think bank loan performance should be better in 2003," the fund manager concluded.

From the point of view of syndication desks, if volume increases and the economy improves, than that can only mean good things to come. "They live and die on volume," Bavaria said.

Issuers have a bit more complex perspective in that if the economy improves business will improve but interest rates will go up so the cost of borrowing - whether it be through bonds or bank debt - will be higher.

"I think your typical company would probably rather have their business be doing a little better and have the economy doing better, even if it means they're paying a little bit more to borrow," Bavaria explained.

Once again though there are some market professionals out there who are not as convinced that market performance will improve in 2003.

"The various constituencies in the loan market have been busy trying to convince people that in fact loans are more stable and less volatile and that on a total return basis have done well compared to other asset classes," Arner said.

"I would say there's probably a little bit of evidence to support that. Whether or not that's enough to convince issuers to borrow money in that market as opposed to anywhere else, I just don't know. I think they're trying to sell the idea that loans are less volatile and provide more stable returns but that's at least partly because other asset classes have been so volatile.

"What we hear from investors is that some of the primary funds have been experiencing redemptions for a little while as the rest of the fund investors have fled to the safer investments. But, as I said, the CLO market has remained strong."

More prime rate fund activity possible

It is possible that prime rate fund activity will pick up in 2003, Arner admitted, if pricing continues to improve leading to better yields and returns.

Prime funds are expected to increase their activity in the market when interest rates move up, said Mike Hatley, president and chief investment officer at ING Capital, at an S&P conference in December. In agreement with this prediction, Howard Tiffen, senior vice president at Van Kampen, said that the market is at a point where the likelihood of an increase in rates is closer than it was previously and therefore, prime funds, meaning retail, may pick up.

In the institutional market, CLOs were the primary investors, accounting for about 75% of the market, according to S&P research that covered market performance for the year up to October 2002. Prime funds accounted for about 20% and 'other' accounted for about 5%.

In order to improve future performance, one must look to the past and learn from it. While reminiscing over the year just ending, many have said that the biggest lesson to come out of 2002 is the importance of credit work. While recovery rates were down - 74.3% for the five-year period of 1998 through the third quarter of 2002 compared to 81.6% for 1988 through the third quarter of 2002, based on two-year holding periods, according to S&P - well-structured loans were not hit as hard as poorly structured loans.

"The major lesson that came through in all the credit, all the statistics, all the loss and recovery data and everything, has been good old fashioned credit work pays off more than ever, especially in tough times," Bavaria said.

"Even though recoveries were down, for example, they weren't down nearly as much for the well-structured deals as they were for the less well-structured deals. That was the real lesson that came through amidst all the bad news this year. It validates doing it right."

And, it appears as of investors have already caught on to the importance of a well-structured deal.

The average rating in leveraged finance loans at Moody's has been higher over the last year or so than it has been in the past, according to Arner, who attributed this outcome at least partially to investors "insisting on tighter structures, better collateral coverage, etc."

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