Outlook 2005: Volume may decline; defaults could cut risk taking; secondary should stay pumped up

By Sara Rosenberg

New York, Dec. 31 - The bank loan market is anticipating a reduction in the overall scale of loan issuance volume as the amount of refinancing and repricing deals in 2005 is anticipated to fall compared to 2004 in response to rising interest rates. However, the jury is still out on merger and acquisition and leveraged buyout financing as some are anticipating volume to stay in line with 2004 levels and others are anticipating a decrease in volume.

One trend that seems to be agreed upon is that tolerance for risk will decrease in 2005 as defaults are expected to increase, leading to higher spreads on the riskier type of deals but not necessarily a decrease in activity.

As for the secondary loan market, levels are expected to remain strong as investors continue to be flush with cash. Furthermore, additional cash may flood into the market as those invested in high-yield portfolios may shift to loans to take advantage of the rising interest rate environment.

Refinancing volume should drop

As interest rates are expected to go up in the coming year, market participants agree that refinancings will probably go down primarily because borrowers couldn't get a better deal than was available in 2004.

"Obviously with rates going up you're not going to be refinancing to a higher rate so you'll probably see a slowdown in refis," a fund manager remarked.

"I mean everybody that has been able to get something done I think has come to the market. You'll probably see a little bit more of it still in the first quarter but I think that slows down after that. I don't know if there's many people out there left that haven't refied. There are probably a few people out there that will try to get something done but I just don't see how that can continue."

"If you couldn't refi your deal this year, there's no way in hell you'll get it done next year," a sellside source said, pointing to the significant wave of refinancing and repricing deals that hit the primary market toward the end of 2004 as a result of "guys wanting to get in before the window closes."

M&A volume in line to lower

While some think that companies' hesitancy to approach the high-yield bond market with interest rates on the rise may lead to a lower amount of M&A loans getting done in 2005, others believe that a good acquisition opportunity will get snatched up no matter what, even if the percentage of bank debt to bonds in a typical M&A deal has to shift.

"We expect volume to be lower next year in high-yield bond issuance due to the fact that rates are getting higher and it will be more expensive for [borrowers] to come to market next year," the sellside source said.

"And, we think that the bank loan market issuance will also come in a little bit just on the fact that if bond issuance comes in, a lot of deals are both fixed- and floating-rate deals, so we'll probably come in a little bit along with them.

"Most borrowers that come to the market want a good mix of fixed- and floating-rate so if they can't get their fixed-rate stuff done it's definitely going to affect us.

"In terms of how much we're going to be affected, I don't know but the feeling out there is that the bond market [will] probably [be] 20% down in volume, possibly more. I would say 20% is probably a good guess on the lower range.

"Sponsors aren't going to want to pay out that high coupon, so absolutely you're not going to see all those LBO deals that are getting done this year and last year; that will also be a huge impact on issuance," the sellside source added.

But the fund manager disagreed.

"I'd say it's probably going to stay consistent with what we've seen probably in this last half of the year," the fund manager said. "It's probably pretty busy with the economy improving. Companies are making money and they'll be more likely to make acquisitions and things like that.

"Companies are going to look at an acquisition and say I need to make this acquisition now, not let it be determined by interest rates. They're looking out for their long-term business prospects and if there's an acquisition out there you got to think that these guys are going to try to jump on it while things are good and it's easy to get money to make an acquisition. Now maybe [the transaction will get done] at a rate that you're not all that impressed with but at least you'll make the acquisition and can refinance at a later time."

"This year we've seen a bit of activity and that was kind of pent up from the past two years basically where activity was pretty slow going so I think you'll see some of this continue at least through the first half of '05.

"Maybe it starts to taper off when rates do get to a certain point but I think right now people have just held off on doing anything because they weren't sure of what the economy was going to do, geopolitical risks, things like that. And now people seem to be a little bit more positive on the economy, that things are improving, that people are creating jobs," the fund manager continued.

The fund manager went on to say that M&A activity should basically stay the same from the second half of 2004 into the first half of 2005, but beyond the first half of 2005 it is kind of hard to tell because it is so far off and anything can happen.

"Looking at it historically we still are enjoying pretty nice interest rates that if you have an acquisition opportunity that provides any sort of reasonable IRR [Internal Rate of Return] on the overall investment it still makes sense to put on 10% leverage to enhance the equity return," said Stephen G. Moyer, CFA, managing director and director of research at Imperial Capital LLC.

"The bigger driver is the amount of cash that is still in private equity and hedge funds that needs to be put to work, and they're going to go out and still try and chase deals.

"One of the phenomena that sort of surprised this year was the number of intra-private equity fund transactions that are occurring. It's surprising how many times private equity fund X is selling a portfolio company to private equity fund Y. I just find that very interesting that two guys that are probably looking for the same kind of return demand are swapping their portfolio companies around as opposed to what was the historical norm [which] would be private equity company picking something up cheap and then looks to sell it strategic or take it public or something like that," Moyer added.

2004 new deal volume

In 2004, $386.9 billion of leveraged loans were sold by 1,412 issuers, according to the sellside source.

By comparison, in 2003 $257.9 billion leverage loans were sold by 945 issuers and in 2002 $211.8 billion leveraged loans were sold by 811 issuers.

Demand should stay strong

Demand for loans is expected to remain strong simply because a floating-rate instrument is more attractive than a fixed-rate instrument in a rising interest rate environment.

"Being we're a floating rate, we think that a lot of new players are going to get involved in the loan market. And guys that are involved already will continue to come to the loan market for new financings. The fact is that the investors like the floating rate in this rising rate environment," the sellside source said.

"Investors will definitely like the floating rate better [than the fixed rate]. Just the fact that the demand will be there, borrowers will have no choice but to go the floating-rate market. And the fact that they'll get deals done and then hopefully in a year or two they can refinance those loans - because most loans aren't call protected and if they are they only seem to be getting a year call protection - I guess they'll get the deal done and then maybe in a year or two rates will come their way again and they'll refinance the bank debt and take it out with a bond offering," the sellside source continued.

"Junk bond spread is at a low over the Treasuries since probably 1998. I think that these guys are not going to be able to get cheaper next year so obviously issuance will go down.

"It's a matter of how much appetite these guys have on the floating-rate side because they'll probably have to end up reducing the bond issuance and increasing the loan issuance, and whether we have enough demand there, time will tell.

"But, on the whole we do expect loan volume to go down. Although when borrowers come to market there might be more of a shift to loans than to bonds but we don't feel that will be enough to offset issuers just not coming to market," the sellside source added.

Risk tolerance expected to decline

Tolerance for risk was extraordinarily high in 2004 as evidenced by issuers' ability to get junkier deals done at relatively low spreads. However, this trend is expected to change in 2005 as defaults start to come in to play and investors start to get stung on their investments.

"I think that's going to change big time," the fund manager said.

"I think next you're going to start to see some higher default rates. People are going to get burned on some names that have been in the market now for a year, a year and a half, and that's kind of the time frame where things start to unwind in some of these companies. Getting burned will force people to say 'wait a second, I got to get paid a little more for the risk I'm taking here,' so I think in the lower-rated stuff you're going to see higher spreads definitely," the fund manager said.

"In general this year everything has been driven by [market] technicals. With all the money in the market, it's kept prices pumped up. I think later on in '05, after the midpoint, you're going to start to see some loans starting to default. I'm just kind of worried [about] credit issues because [people] have been pretty lackadaisical about risk and pretty easy on lending money, and some of these [junkier] deals have gotten done. I think we're going to see some default rates increasing definitely," the fund manager added.

"The market has a ridiculous amount of tolerance for risk right now," the sellside source remarked.

"We expect that to change next year especially on the bond side which goes along with the fact that there will be lower volume issuance.

"With rates rising and Treasuries probably going to yield more next year, the market has to reassess their appetite for risk. Next year will be the start of guys demanding higher yield. I think the market is going to be affected most in the junkier stuff.

"I guess deals will still get done four Bs across the board but the triple hook stuff - those are the guys that are going to be most affected because risk appetite is going to change and guys won't be as willing to lend to those deals. In order for borrowers to get those deals it will have to be an extremely high interest rate," the sellside source continued.

"I think the power will return to the investors next year as opposed to now where they have no power, they're long cash, rates are low and they just need to put money to work," the sellside source said.

"I don't think anytime in the beginning of the year. I think coming out of the box in the new year there will be a lot of deals pricing; guys still have a lot of cash to be put to work. But probably in like five, six months into the year you'll start to see it shift and deals will have more difficulty getting done."

"We've been in a very benign environment, and the market's been hot. Credit spreads have gone down to almost historical lows. While our outlook is that you'll continue to see these corporate earnings, at least through the first half of 2005 depending on exactly how aggressive the Fed gets on increasing rates, as soon as the market starts pricing in higher expected default rates then risk spreads are naturally going to widen," Moyer said.

"A gradual increase in interest rates tightens money supply and makes it more difficult to access the capital markets. The single biggest thing I think prompts default is firms' inability to get incremental liquidity, whether it be going to the bank loan market or tapping the high-yield market to refinance a maturing issue; and over the last two years that was easy.

"Calpine was able to refinance even though leverage on trailing EBITDA basis was almost 10x. In a different credit market environment, they would have been toast. So if there's a tightening in the capital markets by the second half of '05, defaults are going to pick up," Moyer added.

Second liens may be affected

Issuance of second-lien loans is not really expected to decrease in 2005, but pricing on these tranches may be heading higher as investors take notice of the real amount of risk involved in participating in this type of deal.

"Although one might question whether or not investors are receiving the incremental credit benefit that I think the market supposes is achieved with a second lien, they're going to continue to be popular," Moyer said.

"Everybody's going to want to at least believe they have some sort of security attached to their investment. It has benefits in a bankruptcy context. We question whether or not it has quite as much benefit as would seem to be reflected in some of the fairly skinny pricing that some of these things have had," Moyer continued.

"The other aspect of it that needs to be recognized is that it probably increases the volatility recovery toward unsecured pieces of the capital structure when you start increasing the aggregate amount of secured leverage. My sort of macro view is the explosion of all these structured vehicles to absorb these loans, CLOs, CDOs, etc. is over time sort of increasing the amount of secured debt on most corporate balance sheets. And, that's fine as far as it goes, but that generally means that it's subjecting the unsecured claims on those balance sheets to a lot more recovery volatility in bankruptcy scenarios.

"So when we start going through the next wave of defaults which I think will start to pick up significantly in 2006 and 2007 (and may even pick up in the second half of 2005), just because of all the low-rated issuance we've had in 2003 and '04, day follows night and you can expect defaults to start coming a couple of years after the issuance of low-rated bonds," Moyer said.

"I think the giving point there is pricing. It's not going to be investor interest in having the second lien. There's just going to be more appreciation for what the real risk is and desire to be fairly compensated for it," Moyer added.

"I think you'll probably still see a lot of the second lien going on," the fund manager said in agreement, adding that they will probably get done at higher rates.

Secondary should stay strong

Secondary loan market levels are expected to remain consistent with the strong levels that were seen in 2004 since the floating-rate paper will be more attractive to potential investors than high-yield fixed-rate paper in a rising interest rate environment. In addition, CLOs, CDOs and other such investors continuously seem to have tons of cash that they need to put to work, which will only help keep loan prices elevated.

"In the secondary market I think as far as prices on the loan stuff, we're going to be fine," the sellside source said. "I think there will be minimal change as opposed to the bond market where it could go back to like 1999 where those guys got hit hard.

"The fact is, rates are just so low that they have to follow the Treasuries and you have to have a decent spread over Treasuries with this risky stuff, so bond prices really don't have a choice but to go down. But on the loan side we're floating, so hopefully we'll get more guys involved in this asset class, which will help demand, which will keep prices up. The fact that we're floating rate we shouldn't be affected."

"I think as long as money keeps coming into these floating-rate funds like we're seeing, it's going to keep that secondary pumped up because people are just going to be hunting for names and paper all the time," the fund manager explained.

"Supply of paper probably will not keep up with the money that's coming in because as rates continue to go up you're going to see people moving out of fixed-rate bond funds and into these floating-rate loan funds," the manager added.

"CLO issuance seems like it's not slowing down. Money coming into our type of mutual funds continues to pour in, and with what the Fed said [in mid-December] that they're still going to take a measured pace to raising rates, I don't see any reason that money coming into our market should slow down so that money is just going to fuel people chasing down loans in the secondary market so it will help keep the secondary pumped up," the fund manager said.

"I think that's right," Moyer said in agreement. "Just from a macro perspective, if you are facing an expectation of increased rates don't you want to have relatively more floating-rate instruments?

"I certainly allocated more of my portfolio to these prime-type funds. Rates are going to go up, why should I keep my money in this high-yield fund that gives relatively low spread and the risk of spread widening or interest rates floating up? With me; I'm going to go into a bank fund.

"I think historically bank funds perform pretty well coming out of rebounds and into an increasing interest rate environment. So I think there will be demand for them and that will support prices."

In trading, second-lien paper compared to typical first-lien bank debt could see a more pronounced difference, according to Amy Siskind, managing director of the Institutional Bank Debt Group at Imperial Capital LLC.

"Second-lien activity we suspect will pick up next year," she said.

"I suspect there will be less new deals getting done and more of some of the old vintage deals hitting the skids. As interest rates go up, the economics don't work out anymore and I think you'll see a great disparity between where second liens are trading and where first-lien paper's trading. Second-lien people look at it as like a bank loan but it's really going to trade much more like a subordinated bond," Siskind explained.

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