RLPC: Loan demand unfazed by yield compression

NEW YORK Fri Feb 1, 2013 12:50pm EST

NEW YORK Feb 1 (Reuters) - A U.S. leveraged loan repricing spree that sliced spreads dramatically in January still has room to run before a credit bubble forms or an investor roadblock emerges, analysts and asset managers say.

Money is expected to keep flooding into loan mutual funds and collateralized loan obligations (CLOs) as investors are starving for high-yielding assets and eager to minimize duration risk as a growing economy boosts interest rates. Meanwhile, loan spreads remain well above those reached before the financial crisis and all-in yields are similar to those seen pre-crisis while loan structures are stronger.

"Spreads in high yield, whether bonds or loans, are on the tight side of historical averages but are nowhere near pre-crisis tights," said Barclays credit strategist Michael Kessler. "From a strictly spread standpoint, we're certainly not into credit bubble territory. There's no obvious point out there where you would say this has to stop."

Risk-free debt yields are historically low with the Federal Reserve keeping official rates near zero to provide economic stimulus, propelling investors further out on the risk spectrum to increase returns and dragging down interest rates across asset classes.

If the yield curve steepens, with long rates rising and short rates staying flat, it would be neutral for loans while hurting bond returns, Kessler said. As short rates eventually increase, loans benefit because they are benchmarked to Libor.

All-in loan yields are comparable to the pre-crisis period, though the composition differs completely from 2006-2007, he said. At that time there was a small spread on top of a Libor rate above 5 percent, but Libor sank to around 25bp in late 2008.

"Loan investors lost almost all of the income component of their security because Libor collapsed. Now Libor is close to zero, so it can't go materially lower, it can only go eventually higher," he added.

Libor floors in the newer wave of loans are also providing downside coupon protection.

Seemingly insatiable demand for relatively high-yielding assets compelled companies including Neiman Marcus, Dunkin' Brands, ADS Waste and Par Pharmaceutical to push out $1 billion-plus deals last week to slice their loan costs while still offering loftier premiums than most other investments.

This week's repricing wave was just the latest in volley of issuers tapping the market to cut their interest costs. Since the beginning of the year, average yields on U.S. leveraged loans have declined by one full percentage point to 5.15 percent, according to Thomson Reuters LPC.

During that time, investor demand has increased. Bank loan mutual funds have witnessed almost than $3 billion in inflows, according to Lipper FMI. Year-to-date CLO issuance is more than $8 billion with issuance expected to reach nearly $75 billion this year.

In the face of growing demand, leveraged loan supply has fallen short, analysts and investors agree.

"The loan market primary calendar, although it's getting rolling, hasn't gotten ramped up enough since the holidays to really satisfy that demand," Kessler said. "Investors have nowhere else to go but the secondary market, which is why 75 percent of the secondary market is trading above par."

On average, less than half of the market trades over par. Current valuations signal an ongoing repricing wave that will cut yields even further, he added.

In one example, price talk on a $1.67 billion Hamilton Sundstrand Industrial repricing loan is now LIB+300 with a 1 percent Libor Floor and par issue price, compared with the loan's current terms of LIB+375 and a 1.25 percent Libor floor.

John Fraser, managing partner of 3i Debt Management US, said financing costs are compressing along with loan spreads and falling yields, maintaining a relatively stable arbitrage that makes CLO issuance still opportune.

"The number of investors interested in CLO debt liabilities and equity is growing, and that is resulting in a willingness to accept lower yields on CLO debt liabilities as well as slightly lower expected internal rates of return (IRR) on CLO equity," he said.

CLO investors now want an IRR in the low-teens, down from the high-teens, he said.

"Who is to say they might not accept a 10 percent IRR," Fraser said, adding that it is difficult to gauge when investors will put on the brakes.

Fresh off of economic upheaval, recovery rates play a big role in investor decisions.

Loan recoveries bottomed out near 45 percent of par in late 2009, with a long-run average closer to 70 percent, according to Barclays. Those recoveries were 50 percent above those on unsecured high yield bonds in the recession, and nearly double the average junk bond recovery over the long run.

"If investors want, or are meant to be investing in AAA assets, then the question is why wouldn't you invest in a lot of CLO AAAs," said Peter Gleysteen, chief executive officer at CIFC Corp, which manages senior secured corporate loans.

New investors, particularly U.S. banks, contribute to the unrelenting drop in yields and spreads, he said. Still, spreads remain wider than the alternatives, and CLO new-issue AAA spreads over Libor at five times the slim levels of 2006 to 2007 clearly have more room to shrink, he added.

"In addition to regulators requiring banks to decrease their risk profile, arguably one of regulators' biggest concerns about banks is their duration risk or exposure to fixed rate investments," Gleysteen said. "CLOs offer both very high risk adjusted returns and no fixed-rate exposure."

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