Outlook 2012: Secondary market performance for loans may improve

By Sara Rosenberg

New York, Dec. 30 - The secondary market did not see stellar returns in 2011; however, assuming that macro factors, such as Europe and the economy, stabilize a bit, investors may see a rise in trading levels in the 2012 year.

"I would expect 2012 to continue to see an improvement in secondary levels. For the most part, 2011 saw a continued grinding tighter as inflows and demand from accounts saw a robust secondary remain tight relative to the primary market," a source remarked.

"This lasted until European woes and a U.S. debt rating downgrade triggered violent fund outflow and poor liquidity in the secondary, which led to a huge gap in pricing. [This] lasted until a new equilibrium of clearing levels could be reached both in the secondary and primary markets.

"Since then, the global macro situation has stabilized and we have seen the secondary market grind tighter as accounts realized that they aggressively raised cash levels," the source continued.

"I would expect the trend in the secondary to continue to grind tighter in 2012 absent any major macro disruption. Fund inflows should pick up, especially toward the second half of the year as investors realize the Fed's window of keeping rates low until mid-2013 approaches. It will be important to keep an eye on the market toward the end of 2012 as the maturity wall and CLO reinvestment periods ends," the source added.

A market professional backed this opinion, saying that he expects some improvement in trading levels based on the assumption that there will be a gradually improving economic backdrop.

Looking at the secondary market more from a demand perspective, a buyside source remarked that "tighter spreads equals higher prices. Loans are too cheap versus default rates and the yields are attractive versus everything but high-yield. CLOs like buying below par loans, especially with short maturities."

"If we get into a so-so issuance year because economic worries keep new deals down - lower confidence from sponsors - then coupon income is going to drip, drip, drip against the secondary with a bias to below par buys from the still significant CLO base," the buyside source continued.

2011 returns understated

The secondary market in 2011 saw uninspiring returns, with Markit's iBoxx USD Leveraged Loans Index up 0.61% year to date as of Dec. 21 and its new iBoxx USD Liquid 100 Leveraged Loans Index down 0.47% year to date as of Dec. 21.

By comparison, in 2010, the iBoxx USD Leveraged Loans Index was up 11.07% for the year, in 2009 it was up 55.21%, in 2008 it was down 30.84% and in 2007 it was up 1.52%.

"Trading performance has been mediocre in 2011, which is not surprising considering the correlation with the equity market and the poor equity performance," a market source remarked.

"We may see resurgence of sub-par buyback should the secondary levels continue to drop," he added.

"Europe's going to continue to play a role in shaping secondary market in loans. Considering that, it's hard to identify broad based opportunities in loans in specific sectors. Most of the loan investors I've talked to are doing a bottom up analysis. Looking at credits or deals that offer a strong value instead of broad plays," said Otis Casey, director and loan market analyst at Markit.

Casey explained that some of the trends that were seen in late 2011 should continue into 2012, such as there being a lot of cash sitting on the sidelines in loans and people trying to figure out where they can add yield in a low-rate environment.

In describing investor sentiment toward the secondary performance in 2011, Casey said that in the early part of the year people were optimistic as loans were going up, with the expectation being that the year could bring total returns of around 5%.

But, as the year went on, and negative news such as natural disasters hitting Japan, uncertainty in Europe and the U.S. ratings downgrade took over, people ended up thankful that they weren't looking at a loss for the year.

"More liquid names on an individual credit basis have been much more volatile in reacting to the headlines this year. [It] reflects how liquidity is concentrated in more of the flow names," Casey added.

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