It’s been a very long while since the leveraged loans team last did anything on the blog, so here’s an update of where we see the market.
The first thing to point out is that while high yield bonds have started the year with a 10% rally (perhaps making up for the lack of a ‘January effect’ last year!), loan returns have been broadly flat. For the past 18 months, the loans market has been dominated by technicals (ie forced selling) rather than fundamentals, although a clear sectoral bifurcation is emerging – the more cyclical, economically-sensitive areas such as industrials, building materials and chemicals have underperformed those such as cable, healthcare and telco. A credit is doubly favoured by the market if it also happens to be liquid, carries a high coupon and has a high rating. If it ticks all these boxes, then it is seen as attractive to structured credit buyers such as CLOs, and will generally be trading at a 20-point premium to the rest of the market.
Investors’ preference for earnings visibility is unsurprising given the number of credit shocks and other unforeseen outcomes over the last two months. It is unarguable that the long anticipated default cycle is starting, with the US in the vanguard. By value, 4.9% of the US loan market has defaulted in the last year, but the pace has accelerated sharply. In December and January, 3.2% of loans defaulted, the highest two-month period on record, beating the 3.1% posted in May-June 2002.
Thirteen European issuers (five in December, eight in January), representing approximately €9 billion of debt, have defaulted or gone into restructuring. Some were anticipated – UK homebuilder McCarthy & Stone, for instance, while others – eg Italian yacht maker, Ferretti – were more of a shock. German auto parts manufacturers have suffered particularly heavily as it appears that their balance sheets have been strained to breaking point by working capital outflows. So we expect that 2009 will see low levels of new business and high volumes of restructuring as the scarcity of credit and global economic slowdown feed on each other.
Two other trends are worthy of note. First, banks are clearly retreating from capital-intensive businesses like leveraged finance; second, in today’s volatile, non-par market place the practice of using leverage within structured vehicles is untenable. The vacuum from the traditional buyers of loans is being filled by allocations to credit from risk-tolerant, unleveraged investors with longer time horizons; anecdotal evidence suggests that the inflows we are seeing into loans are being replicated elsewhere in the fixed income world.
As always, for institutions looking to invest, the European loan market lacks transparency – there are few public ratings (the bank-dominated European market did not require them), information is generally non-public and insolvency regimes vary widely. But these concerns need to be balanced by the fact that average spreads to maturity are in excess of LIBOR plus 10%, which we believe overcompensate investors for the risks.