| NEW YORK
NEW YORK Feb 1 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
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
"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
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
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
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."