Leveraged loans are the new bonds

This article is provided to FT.com readers by Debtwire—the most informed news service available for financial professionals in fixed income markets across the world. www.debtwire.com

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Early this year, bookmakers would have given a private equity fund trying a leveraged buyout the same odds as a porcine airshow or an ice storm in July. A few trillion dollars of government bailout spending later and the impossible has become merely complicated as buyout shops and their bankers test the resuscitated leveraged loan market with growing regularity.

Barclays launched Friday (20 November) a USD 690m credit facility to help back KKR’s purchase of Northrop Grumman’s government consulting business, while Goldman Sachs will shortly market a hefty USD 3.275bn package for TPG Capital’s acquisition of IMS health. Another LBO loan for Skype was upsized during pricing in early November to USD 730m and is already trading in secondary markets.

“Loan issuance has picked up, really just in the last month,” one leveraged finance banker at a global bank told Debtwire. “The window of opportunity is open for the next few weeks and then it will slow down for the back half of December. But most banks are already talking about what deals will be coming in January,” he said.

Bond issuance resuscitated the junk debt market markets with a flood of new deals starting in April playing a crucial, if indirect, part in the return of leveraged loans. That’s because borrowers used the easy money from high yield funds to pay back short-term or restrictive secured loans, forcing loan-only investors to look for new deals to park their cash.

LBO issuance will continue apace if not accelerate in the near term, said multiple banking, private equity and buyside sources. As more new deals hit the market, bank risk appetite will grow as well, as reflected by Goldman’s full backstop for the IMS Health deal and a Barclays-led syndicate’s full backstop of the TASC deal. The underwritten deals buck the trend of best-efforts financing that started with a rash of hung deals in late 2007, said a second banker and a private equity managing director.

While re-risking continues to spread through the market, the recovery remains nascent, all the sources warned. “Conditionality is still high” on commitments from banks to fund new deals, the PE source said. “They are being very conservative with their conditionality – citing things like market conditions or business conditions – because they just went through a period where that was all tested.”

Selling to buy

The prospect of new supply presents a double edged sword to the asset managers that invest exclusively in leveraged loans.

Most new deals offer a juicier spread, better protection against Libor volatility and tighter covenants than the picked-over paper in the secondary market that originated in the pre-Lehman era, sources noted. But investors will often sell older assets to make room for new deals, creating a built-in drag on secondary trading of benchmark names, several sources warned.

Deal structures have reverted to the “norm” in terms of equity contributions and leverage multiples of 2x-3x through senior debt and 5x-6x total, said the bankers and buysiders. And while many recent deals such as Skype and IMS have featured equity checks of 40% or more, the standard may drop toward 35%, they said. That’s still well above the sub-20% contributions made in 2006-2007.

“Unless there is a return of the natural buyer of loans [CLOs], most investors will in part have to sell the old stuff to make room for the new stuff,” the first PE source said. “It’s a game that’s not very sustainable, and won’t fuel any really big deals.”

The most liquid loan credits have already traded off two to three points in recent weeks, several buysiders pointed out. Georgia-Pacific’s non-extended TLB is now quoted around 95, down from highs around 97, while First Data’s TLB is down two points to the 84 context, according to Markit Loans.

”For the last two years we have been picking over the same crap in the secondary,” said a buysider. “I mean how much TXU can you own? It’s cathartic to see some new issuance and use your credit brain to analyze a new deal.”

What goes around comes around …

Leveraged loans effectively replaced bonds as the junk debt of choice early this decade, when collateralized loan obligation (CLO) managers created a bid for 60%-70% of the secured – and hence purportedly safe – instruments. Bankers and PE shops loved the structures because they could be sold relatively quickly to a private market of hedge funds and CLOs at a relatively low cost for leverage topping off in the high single digits or low double digits.

When investors realized the subprime emperor wore no clothes in 2007, demand for all asset-backed debt, including CLOs, evaporated. That triggered a deep dislocation in the loan markets, setting the stage for the return of the all-but-forgotten high yield bond.

While hedge funds do dabble in junk bonds, the market has been predominantly the playground of unlevered, long-only investors, and those buyers haven’t gone anywhere, pointed out the PE professionals.

And with the bank lending community out to extract a pound of flesh when confronted with covenant violations, issuers largely retreated to the safer high yield bond market where a slightly higher interest rate brought them capital that was not laden with financial covenants. Fear of tortuous amendment negotiations and looming maturities created a wall of supply that has been met by an equally impressive surge of demand.

Fund flows into high yield funds have dwarfed those into bank loan funds this year, according to data compiled by Morningstar. There were USD 17.6bn in year-to-date flows into high yield open-end funds and USD 3.1bn into high yield ETFs. For bank loan funds there were USD 3.6bn in flows into open-end funds, and there are no bank loan ETFs tracked by Morningstar.

For individual investors there are simply more high yield funds to get their hands on. There are 146 high yield open-end funds and three high yield ETFs totaling USD 148bn, while there are 28 bank loan open-end funds and no bank loan ETFs for a total of USD 7bn. All data is according to Morningstar as of 31 October.

The huge transfer from bond funds to loan investors through refinancings – combined with strengthening outlooks for borrowers – is starting the pendulum swinging the other way. “With increased confidence, issuers will increasingly go to the loan market and get a lower rate,” added a second leveraged finance banker.

… and goes around

Of the approximately USD 156bn in year-to-date high yield issuance as of 16 November, USD 71bn has repaid leveraged loans, according to research from Morgan Stanley. “Bond takeouts of loans have definitely had an impact,” one portfolio manager said.

Quantifying that impact varies from investor to investor. One portfolio manager told Debtwire that his loan-only portfolios have received year-to-date paydowns equal to 10% of the holdings, while another reported 5% of his portfolio paid down just during 3Q09.

Those data encompass all paydowns, such as scheduled amortizations, but “clearly the bond market has been the big contributor,” one of the managers concluded.

Loan investors faced with pre-payments re-invested in outstanding loans, boosting secondary markets. That allowed other portfolio managers stuck in underpriced illiquid paper to exit their positions at reasonable levels, freeing up even more capital, said the banking sources as well as numerous loan market buysiders.

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