LCDX index improves; wide bid-offer spreads seen in the wake of dealer inventory reductions

By Paul A. Harris

Portland, Ore., Aug. 29 - The leveraged loan market remained quiet and illiquid on Monday, market sources said.

The Markit LCDX index was trading at 92¼ bid, 92¾ offered heading into the New York close, up 15/16 points on the day, according to a hedge fund manager.

A trader based on the East Coast said that trading was thin and liquidity was very low.

"The names that are bank-held and CLO-held are holding up in price," said the trader.

"Low double B and single B names, which are mostly in the hands of hedge funds and the fast money, are falling."

One example of the latter category is Community Health Services, Inc.'s loan paper (Ba3), which is trading in the low 90s, the trader said.

Air pocket

When the latest significant crisis took hold in the global capital markets, which occurred around the time that Standard & Poor's downgraded its long-term sovereign credit rating on the United States, risk-reduction on the part of the big dealers pushed bank loans 4% to 5% lower, a portfolio manager said on Monday.

That created a technical downdraft in which the index fell to levels that are lower than what economic circumstances and real bank loan prices say they should be, the manager said.

"When the latest credit crisis began, risk managers at the big banks who were keen not to repeat mistakes made in 2008 told traders to pare back inventory, to only get involved in transactions where there was a clear buyer and a clear seller and to stay away from getting involved in the principal," the manager recounted.

"That took out a substantial part of the market's natural bid. It essentially created an air pocket beneath loans."

Hence, for purely technical reasons, the index traded substantially lower - below the prices at which loans are available, the manager said.

One result is a wide bid-offer spread on some bank loans, the buysider said.

Later, a trader confirmed this.

The OM Group Inc. $350 million Libor plus 425 basis points term loan (Ba2/BB-) that priced in July, which the trader characterized as a "middle-market" deal, was trading at 97 1/8 bid, 99 1/8 offered on Monday, the trader said, adding that a deal such as that is typically seen trading with a bid-offer spread of ¼ point to ½ point.

'Great time to be a CLO'

Collateralized loan obligations, which lost quite a bit of par value in the credit crisis, are making up lost ground in a market that has sold lower for purely technical reasons, the portfolio manager said.

Outflows have created a "cash" mentality among some portfolio managers, the investor added, referring to negative flows totaling $4.8 billion in the past four weeks, according to numbers reported by Lipper-AMG.

This has resulted in a lot of loans being oversold, the buysider said.

Loans that were trading at 99 two weeks ago might be marked down as far as 91, although no one is really selling them there, the buysider added.

This situation has created some remarkable buying opportunities, and CLOs are stepping in, the manager said.

"It's a great time to be a CLO because there are a ton of bank loans out there at steep discounts to par.

"So CLOs, which had been using OIDs to maintain and increase their par ratios, can now buy an oversold loan and make much more meaningful headway on those ratios as prices improve."

A trader agreed with that scenario but added that CLOs tend to be fully invested. Hence, in order to go bargain shopping, they need to sell something, which complicates the trade.

September - maybe, maybe not

Market sources were split on the likelihood of a substantial September calendar.

A money manager who believes another round of bond-buying on the part of the Federal Reserve is a strong possibility said that there will be cash to put to work.

Once investors overcome the weak stomachs they developed since late July, they are going to take a look at their possibilities, the investor said.

"They could invest in Treasuries, but those offer a very low rate of return," the buysider said.

"They could invest in stocks, but in a weak economy, the stock market is not especially attractive."

Eventually, "money will start flowing back" into bank loans and high-yield bonds, "which actually offer returns."

"Initially, you will see the secondary market start to be bid higher. That's when the calendar will come back," the money manager said.

A trader was less certain, noting that primary market activity, especially that which is related to mergers and acquisitions, requires a willingness to risk capital.

Whether or not that willingness will materialize in September is an open question, the trader said.

Smart Modular closes

Smart Modular Technologies Inc. said its acquisition by investment funds managed by Silver Lake Partners and Silver Lake Sumeru closed late on Friday.

Funding for the transaction included a new $360 million credit facility led by JPMorgan Chase Bank NA and UBS Loan Finance LLC. The bank debt included a $310 million six-year first-lien term loan B (B2/B+) priced at Libor plus 700 bps with a 1.25% Libor floor and an original issue discount of 90. Call protection is initially 103, declining to 102 and 101. The facility also includes a $50 million five-year first-lien first-out revolver (B1).

Smart Modular is a Newark, Calif., manufacturer of memory modules and solid-state storage products.

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