Risky corporate debt, in both bond and loan format, have been among the most popular credit investments during the past few years. Leveraged loan issuance by sub-investment-grade borrowers last year generated double-digit returns on both sides of the Atlantic. With market chatter now focused on rising interest rates, and better M&A conditions, market conditions could support another banner year.
According to fixed-income data provider Dealogic, global leveraged loan supply surged to $1.3 trillion-equivalent in 2012, up from $1 trillion in 2011, supported by relatively strong underlying corporate fundamentals and the relative attraction of available yields versus similarly rated, unsecured debt instruments.
In the US alone, leveraged loan investors swallowed $465 billion of new issues, the third highest year on record after the halcyon days of 2006 and 2007, according to Standard & Poor’s (S&P) LCD, a leveraged finance data service.
Amid tentative signs of recovery in the underlying US economy, with the Federal Reserve highlighting modest but steady growth in all districts in its latest Beige Book report, US investors are confident that sub-investment-grade loan defaults, currently around 1.3%, will continue to remain well below long-term historical averages.
With leveraged loan defaults continuing to trend some 200 basis points below long-term historical averages, investors remain positive on the asset class in 2013.
“We are constructive on loans globally. We’re still seeing earnings growth from corporate issuers and fundamentals remain strong. There’s been some spread compression but given that default rates are generally below the historical averages, we believe investors are being fairly compensated for the default risk,” says Steve Rixham, managing director and product manager of the global high-yield group at Babson Capital in New York.
With all the new money flowing into the asset class, there has been some spread compression over the past 12 months, but many investors still see upside in loans compared with similarly rated high-yield bonds.
Despite Fed chairman Ben Bernanke’s robust defence of the current phase of quantitative easing (QE) during his semi-annual monetary report to Congress in late February, long-term interest rates have been showing signs of QE fatigue in recent Treasury trading sessions, as the 10-year trends back up to the 2% threshold for the first time since April.
As rising interest rates mean lower prices for outstanding fixed-interest-bearing debt instruments, investors are reaching for the floating rate protection offered by the leveraged loan product format.
“While the all-in yield level between high-yield bonds and leveraged loans is about the same, loan investors benefit from secured positions in floating rate instruments that offer higher returns as rates rise,” a high-yield focused portfolio manager says.
CLOs (collateralized loan obligation) are a form of securitization that survived the financial crisis with their reputation and performance intact. These vehicles work by buying loans and then selling securities at a lower interest rate to institutional investors. The bull market in leveraged loans is being driven, in part by the continued appetite of CLO buyers with $55bn of CLOs launched in the fourth quarter 2012.
With loan default rates substantially higher in Europe – ending 2012 at around 6% of principal outstanding, according to S&P LCD – the fundamental picture is not as compelling.
Indeed, while loan supply ballooned in the US, European volumes suffered sharp declines as the leveraged buyout activity, which typically drives loan refinancing, dried up amid broad-based economic uncertainty.
However, of course, lower prices mean yields are correspondingly higher and, buyers say, the investment rationale remains intact, particularly in the secondary market, given the absence of new issuance.
“With a lower entry point, Europe has a more potential for total return,” says Rixham, pointing to opportunities to acquire performing loans at five-to-10 points below par.
Both institutional and retail investors continue to pour money into leveraged loans – $9.1 billion so far in 2013, according to fund data provider Lipper – so the US market, at least, seems well positioned for another big year.
In early February, leveraged finance investors digested Dell’s leveraged buyout (LBO), which included more than $5 billion of loan issuance, the largest single loan in the US LBO market since 2007.
“The forward calendar of M&A-related loans ended January 2013 at $22 billion, up from $13.5 billion at the end of 2012,” says Steve Miller, managing director with S&P LCD in New York.
In Europe, meanwhile, the M&A calendar is substantially less full. Corporates are, for the most part, cash-rich, having funded themselves conservatively after the onset of the crisis, which means the market is relying on secondary buyouts.
However, there are signs of life in the European M&A sector highlighted by Liberty Global’s $23.3 billion acquisition of Virgin Media, financed in part by £2.3 billion of high-yield bonds and a $2.7 billion leveraged loan.
There is one clear consequence: this M&A boom, and balance sheet re-leveraging, will no doubt make corporate bondholders nervous.