NEW YORK May 9 The significant supply and demand imbalance that has largely defined the U.S. leveraged loan market for the last two years, with unrelenting investors chasing too few deals and driving yields lower, may finally be finding an equilibrium.
On the heels of 95 straight weeks of record inflows into bank loan mutual funds, retail investors reversed course in early April, marking the first outflow in nearly two years. At the same time, the long awaited rise in new money dealflow is finally materializing. Together, the tempering of excess liquidity and the emergence of new paper is taking the edge off what has been an overheated market.
The consensus is that this cooling off does not constitute a market correction or fundamental shift, but rather a rebalancing back to the natural ebb and flow of supply-demand dynamics between issuers and lenders. Lenders are getting choosier and issuers are altering some terms to comply with investor demands.
"I think things have been brought into balance," said Jon DeSimone, managing director at Sankaty Advisors.
In or out
Beginning the week ended April 16, bank loan mutual funds recorded three consecutive weeks of outflows followed by a modest $68.6 million in inflows the week ended May 7. During that three week period retail investors extracted more than $900 million in cash, though it is worth noting that the pace of retail demand was already slowing as evidenced by more moderate weekly inflows before turning negative.
At the same time, increasingly robust collateralized loan obligation (CLO) issuance has anchored demand on the institutional side, offsetting the negative retail flows. CLO volume stands at $38.3 billion year to date, with CLO formation expected to remain strong through the remainder of the year. This is up from $33.26 billion a year ago.
On the supply side, a growing pipeline of new money deals, buoyed by a hefty lineup of M&A transactions, is also a welcome reprieve for investors weary from the torrent of opportunistic refinancing and dividend recapitalization transactions that hit their desks in 2013 and early 2014.
"We've got in the pipeline Charter, Safeway, Zebra Tech, Post/Michaels and Gates LBO. It's going to remain busy, and it's going to remain a lot of new money supply, so I think it's going to be more of a balanced market," one leveraged banker said.
M&A on the way
M&A and LBO deals currently comprise roughly 43 percent of the institutional leveraged loan pipeline, which stands at approximately $60 billion, according to Thomson Reuters LPC data. That volume does not include forthcoming acquisition-related contributions from issuers Charter Communications and Valeant Pharmaceuticals.
The scaling back of the retail bid has brought some relief from the excess liquidity flooding the market in search of a home, said one institutional investor, comparing the tempering effect to tapping the breaks.
The resulting smaller pool of capital and uptick in new money supply means investors are now able to be more selective in how they put money to work. Loan buyers have more choice, investors noted. No longer under pressure to buy any deal at ever lower pricing with increasingly aggressive terms and deteriorating structures, investors are pushing back on credits or deals considered to be more risky.
Lenders are primarily asking for more spread, as well as higher amortization or the addition of covenants and other investor protections to get certain deals over the line. Since the beginning of May, a dozen issuers have flexed spreads up, while only one has cut pricing.
At least three proposed deals have also been shelved due to market conditions. Software development firm Rocket Software withdrew a proposed $725 million covenant-lite loan to refinance existing debt and fund a dividend to financial sponsor Court Square Capital. Apparel manufacturer Dutch LLC and specialized acute care provider Capella Healthcare pulled $200 million and $585 million refinancing efforts, respectively.
In the last couple of years, the greatest drivers of liquidity have been mutual funds and resurgent CLOs. In search of yield and seeking exposure to rising interest rates, retail and institutional money alike piled into floating-rate leveraged loans, pressuring yields to dramatic lows.
Now upward pressure on pricing is sending yields higher quarter to date. So far in 2Q14 the average yield on first-lien institutional term loans is in the 5.18 percent context, up 46bp from 4.72 percent in 1Q14.
The CLO machine is widely expected to continue chugging along in 2014 suggesting CLOs will likely remain a significant and stable buyer of leveraged loans. The retail bid is more unpredictable.
"The unknown is retail. Loans have penetrated the retail investor base, and they may now have the allocation they want. Whereas before they didn't have it and were adding the exposure to their portfolios," said DeSimone. "Now it will depend on the relative attractiveness of loans to other asset classes." (Editing By Lynn Adler and Jon Methven)