Outlook 2013: Spreads, OIDs, Libor floors may tighten with positive technicals

By Sara Rosenberg

New York, Dec. 31 - Spreads, original issue discounts and Libor floors on leveraged loans may all come in during 2013, versus average 2012 levels, as market technicals are expected to remain strong. But, even with high demand, some are questioning whether pricing could get any lower.

"All the reasons for positive technicals that exist now should exist next year - CLO bid, lousy investment-grade yields with no up rate protection, and stretched high-yield valuations that make the up in quality trade to loans look attractive to all but the most committed yield hogs," a buyside source remarked.

"As long as the economic backdrop is flat to up, spreads will tighten as more money flows to the category from CLOs, investment-grade and high-yield portfolios. Hoping 25 to 35 bps tightening in 2013," the buyside source continued.

However, a sellside guy disagreed, saying that spreads will either be similar to higher in 2013 when compared to 2012 as the "market has no room to go lower. We are at the floor."

A market professional agreed with both sides, remarking that spreads will be the "same or tighter, given what will likely be a lack of true new supply coming into the system."

OIDs could narrow

Like spreads, as long as demand stays strong, original issue discounts could get smaller and smaller, some sources said.

"Some managers really like OIDs and some prefer coupons, but both will get less or more attractive to reflect technicals. Again, assuming flat to up fundamentals, technicals should be good in 2013 so OIDs should tighten," the buyside source remarked.

He guessed that the average OID in 2012 was 99, and that it could be 99½ in 2013, "all else equal, which it won't be."

The sellside source, however, expects original issue discounts to be around 99, "same as 2012 average."

The market professional remarked that OIDs "will remain and may tighten some if investors have to start scrambling for assets. CLOs prefer to buy with some OID because it helps them build operating capital in the vehicles. Real money accounts like to buy with OID because it helps total return and gives them some cushion in a down market. It would surprise me to see the majority of first-lien new issue come at par. Second-liens will definitely continue to come with OID, which is needed to enhance returns and create synthetic call protection."

Libor floors to stay

While demand could create an environment for smaller Libor floors, they are expected to continue to be part of the leveraged loan landscape due to the low level of Libor.

"The basic yield of a new issue loan needs to be better than investment grade and lower than high-yield. You need floors to get that level today without making the spreads ridiculously high because the government has made Libor so artificially low. So floors remain, and the level will reflect a balance with the spreads the issuers will accept. As technicals are strong, all factors in return should tighten," the buyside source explained.

"[Floors have been] very consistently 1.25% for many months now for an average deal. As in my earlier answer, floors and spreads are a combo deal and will reflect required yield versus what an issuer is willing to lock in for spread," the buyside source added.

"Rates are not going up in the near-term to a point that the floor will become unnecessary. 1.25% will be the norm, similar to 2012," the sellside source remarked.

The market professional agreed that floors will stay for the foreseeable future given the low interest rate environment, but he guessed that "top-notch issuers will probably start to get 75 bps floors, down from 100 bps."

Middle market deals

Regarding middle market loans, one source said that he expects spreads to tighten because CLO issuance will top $50 billion and that influx of money will move spreads a bit lower.

"The market can probably get to a Libor plus 400 [bps] level with 1% floor as an average. We are at the lower end of average historical all-in yields so 5% feels a little tough to penetrate, but that's just a gut feel. Could go a little lower," one source remarked.

"Libor floors will remain as long as rates remain so low. 1% to 1.25% will be the market. Average floor was 1.25% for the full year [2012] but between 1% and 1.25% for the fourth quarter," he continued.

As for original issue discounts, the source expects them to "stay in the 99 to par zone. We'll see better quality deals get to 99.5/par but I think investors still want to be paid a little something up front."

More covenant-light deals?

There were a slew of covenant-light deals marketed in 2012, especially in the back half of the year, and if the market stays as positive as expected, there will likely be more of those in 2013.

"Covenant-light is a good indicator of supply/demand balance. Given expectations of continued positive technicals, I expect covenant-light to continue to grow. Credit quality is far more important to returns than the existence of a single maintenance covenant," the buyside source said.

"Covenant-light is a hot/cold item. Running very hot now. Can't predict when it will cool, but it will," the source remarked, adding that a 25% covenant cushion on a single total leverage covenant will continue to be the standard.

The sellside source, meanwhile, said that there will be more covenant-light deals in 2013 because the market has become more accepting of those types of transactions.

"Cov-light will continue as more inflows come to the market and the overall default rate remains low. Overall volume will be a function of supply/demand balance. If the market is starved for paper, there will be a surge of cov-light," the market professional added.

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