Liquidity Picks Up in Loan Market; Issuance Slow to Follow

Leveraged lending experienced a muted recovery in 1Q10. At $71.40 billion, issuance was more than twice 1Q09’s anemic levels but down 16% from 4Q09 levels, according to Thomson Reuters LPC. Although lender and investor appetite improved on the margin in the loan market, issuers relied on the bond market and on amend and extend loan structures to push out existing debt maturities and lock in longer-term liquidity. There were nearly $26 billion in extensions in 1Q10, on the heels of $62 billion in 2009. The refinancing cliff that loomed large in 2009 also was flattened as nearly 40% of total 1Q10 high yield bond volume (or over $23 billion) was used to pay down loans, following the $74 billion recorded in 2009, according to Thomson Reuters.

The supply of new loans remained limited and investor demand outpaced it, resulting in a nearterm supply-demand imbalance. CLOs were the dominant buyers of institutional loans as they continued to accumulate liquidity from loan repayments and bond paydowns – although their share of the institutional market has declined. Loan mutual funds, although a smaller component of total institutional demand, were also active buyers in the market with loan mutual fund net inflows totaling $2.9 billion in 1Q10, compared to $2.4 billion for high yield bonds, according to Lipper. Hedge funds, insurance companies, high yield bond investors, private equity shops, and finance companies continued to participate on a selective basis.

On the back of strong buyside demand, both bank and non-bank lenders surveyed by Thomson Reuters LPC expect institutional issuance to continue to climb in 2Q10. In fact, institutional loan issuance (drawn leveraged loan tranches sold to institutional investors) reached $35.54 billion in 1Q10, up dramatically from the same time last year when the market only pushed through $2.45 billion, but also up from 4Q09 when issuers secured $23.68 billion in institutional commitments as the loan market showed the first signs of recovery. Sources expect issuers will continue to opt for amend and extend facilities in the near term at the expense of full credit refinancings.

Strong loan demand also drove up secondary bids to levels reminiscent of 2008. The SMi100 landed at 94.79 on March 30, up 2.67 points this year. Roughly 76% of all loans tracked in the secondary market are now bid above 90 compared to 10% at this time last year, according to LSTA/LPC Mark-to-Market Pricing. Covenant-lite loans are bid in the 91.6 context, having come up from their bottom of 57.6 in December 2008, according to Thomson Reuters LPC.

With many high-quality loans bid around par, investors are increasingly looking to the primary market for new issues. In this context, yields on new issue loans have come down and deals have been oversubscribed. Libor floors dropped to the 1.5-2% range, original issue discounts (OID) tightened with the majority of deals offering a 99 OID, while the spread over Libor continued to vary by risk. Investors nonetheless remained selective and several deals required higher yields in order to clear market, based on the issuer’s industry, use of proceeds, leverage profile or other factors. The average primary yield on new issue loans is in the 6.5% context.

Yields declined in the investment grade market as well (issuers rated BBB-/Baa3 or higher). Drawn spreads, while down in 1Q10, remained above pre-credit crunch levels and for higherrated borrowers, continued to be tied to the issuer’s individual CDS spread or the CDX index, often in combination with a spread floor and cap (a pricing mechanism referred to as Market Based Pricing). Roughly $16 billion in facilities were structured with Market Based Pricing in 1Q10, on par with 1Q09 but down from $31 billion on 4Q09.

Undrawn spreads for 2010 issuers across the ratings spectrum were lower than those on 2009 deals but higher than pre-credit crunch levels. Investment grade lending remained tepid in 1Q10 at $55.7 billion, falling below 1Q09’s $65.39 billion. A lack of jumbo M&A transactions coupled with issuers’ reticence to return to market to refinance existing debt resulted in a slow quarter. With spreads trending downward, lenders state that some issuers are holding off on refinancing maturing credit lines in anticipation of the return of longer loan tenors and still thinner spreads.

Sources expect that a five-year revolving facility will probably emerge in 2Q10 to test the market. Banks have appetite for assets after experiencing massive run-offs and anemic issuance levels in 2009. The majority of high-grade issuers typically refinance in 2Q10. Whether this holds true for 2010 remains to be seen. For now, issuers are focused either on refinancing now or waiting for conditions to become even more favorable.

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