Outlook 2007: Secondary bank loan market expected to remain stable

By Sara Rosenberg

New York, Dec. 29 - The secondary loan market is anticipated to hold steady in 2007 with new issues continuing to free up in the par to 101 type context and typical trading levels staying in the par context based on the general economic outlook.

In terms of the new issues, what will determine their performance is supply and demand, a buyside source remarked.

For example, if the recent leveraged buyout trend continues into 2007, which is what most market players are expecting, then break levels on new issues should be relatively unchanged on a year-over-year basis. However, if supply starts to fall short, then investors will pay up for the new paper.

"One aspect of the break price that may not be clear is the number of hedge funds getting flipping allocations from dealers. When hedgies can't rely on the flip, they don't play in the primary and the break price is lower because more real money accounts get filled. That's a self-reinforcing cycle in both directions. The big pick up in supply in the early summer happened just as hedgies were being nailed by weakness in other markets. Their exit is a major reason break prices normalized in the second half," the buyside source added.

As for general market trading levels, a big player in determining performance is the economy and since most are not expecting any major events in 2007, things should stay firm.

"I doubt much bad stuff will happen in 2007 from normal economic developments," the buyside source said. "The economy does not look ready for a recession next year. Thus 2007 should be another happy year for loans, though perhaps as the year goes on a bias to higher quality will start to be evident. In that environment, I expect secondaries to generally flop around par, though perhaps with a slight bias down as high-yield yields are relatively tempting to the sanguine."

The source went on to say that if defaults turn up, mutual funds and possibly CLOs may pull back from the secondary market, creating a situation where prices may fall. But, once prices are lower, CLOs would likely jump back in the game, restabilizing the market.

"An open question is whether johnny-come-lately institutions will get in their gut what CLO investors know - loans will ride out the downcycle very well so staying out of the category makes no sense. The same question goes for liquidity providers - will they lend less to a category that's declining in price? Their pay-down provisions will certainly start kicking in. So I think there will be technical disruptions as defaults increase that may spook less thoughtful participants, but the through-the-cycle view remains good.

"Worldwide liquidity remains strong and non-investment grade default losses remain low. As long as that is the case, there will be a lot of demand for bank loans. Beyond the boom in CLOs, we are seeing increasing numbers of custom structured product searches by institutions that use bank loans to provide a Libor base off of which futures and other features can be added to deliver the desired risk/return trade-off. Leverage is usually a part of the picture, which amplifies demand for loans," the buyside source added.

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