* Bond/loan agnostic funds prompt loan market volatility
* Sub-investment grade borrowers face tough decisions
* Differences between products could wrong-foot investors
By Robert Smith
LONDON, July 11 (IFR) - Junk-rated companies are finding it harder to shield themselves from market volatility, as the growing number of nimble leveraged funds that can invest in both loans and high yield bonds gradually erodes pricing dislocations in the two markets.
Issuers have traditionally sought refuge in the loan market when bonds have become choppy, but they are now having to weigh more carefully the relative merits of each asset class.
Price flexes on leveraged loans sold by cable firm Altice and insulation firm Armacell last month show the increasingly reactive nature of the European loan market, which leveraged finance bankers partly blame on product agnostic funds.
Investors such as Babson Capital have funds that can buy both bonds and loans depending on where they see value, while some new CLOs have bond buckets as large as 40% or 50%.
“Loan investors have not historically been quick to react to broader market volatility, but as the underlying investor base for bonds and loans converges and more mark-to-market funds play loans, volatility will begin to pervade the loan market as well,” said Peter Hurd, managing director, acquisition and leveraged finance, capital markets at Nomura.
For issuers, the new pricing dynamics mean that optimal funding options are less clear cut.
When OMERS Private Equity and Alberta Investment Management began readying the debt financing for their buyout of Vue Entertainment at the start of June, the focus was on tapping the high yield market.
In the wake of the volatility triggered by Bernanke’s FOMC speech on June 19, the pair sounded out loan investors to gauge demand, but seeing no pricing advantage, decided to stick with bonds. The decision paid off, with investor demand driving pricing on its fixed rate bond below 8%, tighter than guidance.
The pace at which the loan market is now playing catch-up has caught other issuers off-guard.
Altice had to abandon its euro loan altogether this month after failing to drum up enough demand, while sharply increasing the pricing on its dollar loan as volatility flared.
Initial guidance on the dollar loan was between 375bp and 400bp with a 99.5 original issue discount (OID), but the deal eventually priced at 450bp at a significantly larger OID of 94.
“The loan market is normally a laggard, so to move 75bp in two weeks is huge,” said a banker on the deal.
“Recently, loans have traded 150bp inside where bonds would come and I think loan investors have been keen to correct this when putting new money to work.”
According to AFME, in the first quarter of 2013, institutional leveraged loan spreads in Europe averaged less than 450bp. In contrast, the high yield FRNs issued in this period had a weighted average margin of 568bp.
With institutional loan investors now looking to close the pricing gap, borrowers will have to consider more closely which market caters to their needs. If investors look to close the gap on covenants as well, it will complicate the issue further.
Jermaine Jarrett, head of high yield syndicate at Mizuho, said the emergence of European covenant-lite loans could create even more price tension between the two markets.
“One of the big factors that helped sponsors come round to bonds is the lack of maintenance covenants. But if they have the opportunity to issue cov-lite loans, they not only achieve the same but they also retain pre-payment flexibility.”
These new pricing dynamics could become the new norm, if the number of sub-investment grade funds able to dip in and out of both markets continues to grow.
“We’re in a changing world, and one that is changing in much shorter time periods,” said Ranbir Singh Lakhpuri, portfolio manager, leveraged finance at Insight Investors.
“In this environment you’re better off with a broad platform that allows you to select different asset classes, rather than a one product shop.”
Loans have been a good way of achieving short duration in portfolios for traditional bond buyers, while loan investors faced with thin supply have turned to floating rate bonds.
The convergence of the buyer base has had its downsides, investors say. Not only has it weakened the loan market’s covenant discipline, but call protection on bonds has become softer.
“The call protection on high yield bonds has eroded to the point where price upside in the secondary market is almost as limited as it is for loans,” said Peter Aspbury, a high yield portfolio manager at JP Morgan Asset Management.
Some investors may also be wrong-footed in a distressed situation, as senior secured loans and bonds behave differently despite being nominally the same part of the capital structure.
“Investors will prefer to own the first lien loans in order to have greater influence over enforcement actions given contractual restrictions on many senior secured bonds’ voting rights,” says Aspbury.