Leveraged loan technicals seen still robust but "fraying at the margins"; second-lien issuance growing

By Paul Deckelman

New York, June 16 - The market for leveraged loans continues to grow - although the pace seems to have slowed, in line with recent credit-market developments.

Some degree of "fraying at the margins," is how Steven Miller, the managing director for leveraged commentary and data at Standard & Poor's put it at a high-yield debt conference earlier this week in New York.

Miller told attendees at the New York Society of Security Analysts' annual high-yield conference on Wednesday that the loan market technicals remain robust - for instance, new-issue institutional volume is up 27% on the year through May - but much of that came earlier in the year, and that pace has slowed in the second quarter.

He also noted that not only are spreads on second-lien loans wider - but even liquid large first-lien loan prices are off by about 100 basis points from the levels they held when the market peaked in March.

And overall market risk continues to increase, with single-B rated loans dominating the primary, issuers having more aggressive credit statistics, some borrowers who would have otherwise sold bond issues opting instead for second-lien loans, and banks now more inclined to give their borrowers more covenant headroom.

According to data compiled by the ratings agency and presented by Miller at the conference, new-issue institutional leveraged-loan volume from the start of the year through the end of May totaled $124 billion, up from the $99 billion seen in the same period of 2004. For all of 2004, loans totaled $265 billion, the peak level since leveraged loans took off as a major corporate financing tool in the late 1990s, coinciding with the big surge of high-yield borrowing in 1997-1999.

Miller said that a lot of the first-quarter loan activity was connected with merger and acquisition activity. Going forward, he said, while there are some lager M&A-oriented deals that will be coming to market in the near future - such as the Sungard Data Systems Inc. transaction and, a little further down the road, the financing for Global Toys Acquisition LLC's pending leveraged purchase of Toys "R" Us Inc., the market is otherwise "not that busy. We'll see it pick up from its [relatively low] May levels - but it won't be like the big first quarter M&A push."

As has been the norm ever since 2003, most leveraged loan volume has been in institutional term loans, with interest paid throughout the term of the loan and the principal repaid at maturity, as opposed to pro-rata tranches consisting of an amortizing term loan (principal and interest both repaid through the term on a progressive payback schedule) and a revolving credit facility. Prior to 2003, pro-rata tranches accounted for the bulk of leveraged loan activity.

Pro rata sector still active

Even with a reduced share of the total leveraged loan market, pro-rata lending is still an active niche. While the number of active pro-rata lenders - mostly banks - stood at between 50 and 60 as of the end of the first quarter on March 31, only about half of the more than 100 such lenders in the market in 1999, "there's going to be a lot of this kind of activity in the second half as the banks re-engage," said Miller, "with aggressive loan writing."

He outlined several recent deals in which institutional tranches carrying higher interest rates were refinanced, in whole or at least in part, as pro-rata revolver tranches with lower rates, "taking the deals out of institutional hands." Among these were deals for Triad Hospitals Inc., whose $1.1 billion deal earlier this month taking out the institutional investors picked up 100 basis points, cutting its rate down to Libor plus 125 bps from Libor plus 225 bps, Miller said, while Cumulus Media Inc. is expected to soon close on a new $700 million facility at 125 bps over Libor, a 50 bps improvement over the old facility being refinanced.

That having been said, the institutional segment remains the larger portion of the leveraged loan market.

Institutional investors such as collateralized loan obligation accounts, insurance companies and pension funds - long players in the higher-grade types of loans - are taking an increasing interest in the leveraged loan market, with about 200 of them now buying almost two-thirds of the loans.

From only a handful, that number steadily grew throughout the 1990s and the early years of the decade, shot past 100 in 2003 and has continued to strongly grow since then, with Miller saying that at least two or three new buyers come on board every month. They are drawn by the relatively higher yields such loans offer when compared with loans to higher-rated borrowers - while still enjoying the safety and security of bank debt in a low-default environment.

Overall default levels by most measures are hovering just under 2% - and loan default levels are around 1.3% - and expected to stay that way.

However, Miller pointed out that in the riskier kinds of loans to less credit-worthy borrowers - so called "high-octane loans" done at rates 400 basis points or more off Libor - the composition of the investor pool changes markedly. While CLO accounts still account for 61% of the loans, versus 65% for the overall leveraged institutional loans, hedge, high-yield and distressed funds, which hold about 9% of the overall market's loans, hold about 25% of the high-octane loans - and during the default binge in 2002-03, that percentage was around 50%, although it has since stabilized at the lower level in recent months. Insurance companies, famed for their conservatism, hold about 5% of the loans in the leveraged market - but only about 2% of the high-octane paper.

Only about 1% of institutional leveraged loans are considered distressed loans - those loans trading at or under 80 cents on the dollar - a percentage which has come down steadily from its recent peak of around 6% in the fall of 2003, and is well below its historic zenith around 13%, a dubious milestone reached in early 2002.

"Right now, the pool of vulnerable loans" considered distressed or about to fall into that category "is very low," Miller said.

Reflecting the overall conditions in the debt markets, leveraged loan yields, after having peaked in 2002 and then having choppily zigged down to near-historic lows earlier this year, zagged back up in May, up about 25 bps from their April lows. However, Miller said, "spreads have tightened over the last week or so," down to 180 bps from 210 bps previously for loans rated BB/ BB- and down to 275 bps from 300 bps previously for loans in the B+/B category.

Hedge funds step back as junk yields rise

He said that the relative-value gap between leveraged loans and high-yield bonds, which was only 30 basis points at the end of 2004, has widened out sharply to a peak of around 300 bps by mid-May, as junk bond prices fell and yields rose amid dried-up liquidity and negative events such as the ratings downgrades for General Motors Corp. and Ford Motor Co. bonds.

That, in turn "caused the hedge funds to take a step back from the loan market as high-yield spreads widened strongly," Miller said, "after having been right on top of the loan market at the beginning of the year."

Over the past several weeks, however, the S&P analyst noted there "there had been a big comeback in the high-yield market," fueled by a surge in liquidity (with more than $1 billion of money coming into junk mutual funds, an important indicator of overall market liquidity trends, in a two-week period), and the bond market having pretty much gotten over its initial retreat following the Ford and GM downgrades. The 300 bps gap between the two markets had narrowed in that time to about 225 bps, Miller said.

But on the supply side, with ample liquidity in the leveraged loan market and a continued low default rate environment, the banks are continuing to ramp up their loan activity. The unsettled conditions in the junk market earlier in the year caused some would-be bond borrowers to do second-lien bank loans instead, including such names as White Birch Paper Co. and Stile Acquisition Corp. (Masonite), as well as Hughes Network Systems.

"I thought that [second lien loans] were bear-market products and would come down this year," after having spiked up to about $12 billion in 2004 from one-quarter of that level in 2003, "but that didn't happen," Miller said. "The banks are writing more second-lien loans as high-yield [issuers] have backed off. Second-lien issuance from January through May of this year came to around $8 billion - beating the previous year's pace during that same period.

Lower rated issuance grows

At the same time as more potential borrowers are lining up to do bank debt instead of bonds, the banks are taking a somewhat more tolerant view of the credit quality of their prospective customers.

"The 4B type deals that used to dominate the market," particularly during the turbulent period of 2000-2002, when they accounted for over 75% of leveraged loan market new issuance, "are now less a presence," Miller said. "Single-B is now growing, and the banks are more aggressive in pricing." That lower-rated segment of the market, he said, accounted for just over 50% of issuance by late May.

The banks are also giving their borrowers more breathing room when it comes to covenant compliance. By the first quarter of this year, the average permissible first-year debt-to-EBITDA coverage ratio in LBO deals had grown to 6.2 times, from 5.8 times in 2004 and from the recent low of 4.2 times in 2002.

S&P projects that the average first-year LBO borrower will have a debt totaling about 4.8 times EBITDA - with the debt level having crept back up from 4.6 times in 2004 and 3.4 times in 2002.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.