Leveraged loan volume in the U.S. was large and lumpy during the first quarter of 2006. Total new-money volume during the first three months of the year soared to $109 billion--the most since Standard & Poor's Leveraged Commentary & Data (LCD) started tracking volume in 1997--up from $74 billion in the fourth quarter and from $80 billion during the same period in 2005 (the prior record was $85 billion in the second quarter of 1998).
This explosive growth was due largely to M&A-related jumbo financing. The Georgia-Pacific (GP) LBO loan package set the pace, of course. At $11 billion, it is the largest leveraged loan execution since at least 1997 and is likely the second-largest ever, behind RJR Nabisco's $13 billion LBO loan from 1989. GP was just one in the pantheon of large first-quarter deals. During those three months arrangers rolled out nine leveraged loans of $2.5 billion or more, approaching the record of 14 for an entire year, established in 2005.
In the institutional market, the parade of elephants was even more impressive. With these big deals coursing through the loan market, the average leveraged loan in the new-issue market during the first quarter soared to $482 million--second only to the $577 million during the first quarter of 1997--up from $271 million in the fourth quarter and from $299 million for all of last year.
Looking ahead, arrangers report a healthy calendar, though they would like it to be busier. Most expect second-quarter activity to be a letdown after the first quarter's furious pace. The recent trend supports this view. After jumping to a record $52 billion in January, loan volume slowed to $25 billion in February and $33 billion in March. Arrangers expect leveraged lending to remain M&A driven in the second quarter, including a fair share of large deals. Already two big transactions are on the horizon, Alltel ($4.2 billion) and Supervalu ($4.0 billion). Arrangers report that front-end activity by sponsors remains strong. But arrangers generally expect new-issue activity in the second quarter to drop from the extraordinary heights of the first quarter and be closer to the recent quarterly average of $74 billion total.
A Loan Market On Steroids
It is said that one can never be too rich or too thin. But don't tell that to loan investors. The market today offers (in the nicely turned phrasing of economist Jim Grant) "fewer bargains than the typical hotel minibar." In addition to accepting skinny spreads, institutional accounts are forced to buy the sort of paper they have traditionally avoided, including "covenant-lite" loans (those that are free of customary lender restrictions) and delayed-draw loans.
First, a review of some of the headline trends that illustrate today's steroid-laced loan market technicals. New-issue spreads illustrate this point. A key benchmark measure, the spread on loans rated 'BB' or 'BB-' by Standard & Poor's, fell to LIBOR plus 168 basis points (L+168), on average, during the first quarter. This is the narrowest reading on record, besting the previous low of L+175 set during the fourth quarter of 2005. Spreads thinned out as the first quarter wore on. The average BB/BB- spread, in fact, declined to a new low of L+164 in March, from February's mark of L+168 (there was one tighter intramonth reading in LCD's data series: L+160 on Oct. 7).
Spreads on 'B' rated loans also tightened in the first quarter, though they remained atop all-time lows. During the opening three months of 2006, the average B+/B spread dipped to L+254--five basis points wide of the first quarter of last year, when the average bottomed out at L+249--from L+271 during the fourth quarter. The March average was also L+254, up a tick from February's reading of L+253, but inside December's average of L+266. When looking solely at loans rated 'B+' by Standard & Poor's and 'B1' by Moody's Investors Service, spreads also hit new depths. Arrangers rolled out five such institutional credits in March. The average clearing spread: a breathtakingly thin L+205, down from L+244 in February and 33 basis points inside the prior low of L+238 from March 2005.
Heavy Use Of Covenant-Lite Loans
Technicals being what they are, issuers found a reliable, though reluctant, market in the first quarter for covenant-lite term loans. In fact, this was the breakout segment of early 2006. During the first quarter, arrangers unveiled five covenant-lite loans totaling $5.4 billion. To put this number in perspective, this is 59% of all covenant-lite volume that LCD has tracked since 1997, blowing away the prior quarterly high of $2 billion from the third quarter of 2005, when Neiman Marcus was the sole borrower of a covenant-lite loan.
The first quarter's volume surge was paced by Cablevision's $3.5 billion loan (rated 'BB' by Standard & Poor's and 'Ba3' by Moody's Investor Services), at L+175. This deal shows that lenders are being paid little to give up covenants. Perhaps a full-covenant, BB/Ba2 loan would have cleared at L+137.5-150. Arrangers expect covenant-lite volume to continue to grow in 2006, assuming that technicals remain supportive. Certainly, this type of facility has captured the imagination of private equity firms, arrangers say, as a way to avoid coming back to the table if financial performance deteriorates. By contrast, when a loan has maintenance covenants, lenders are often able to wrestle concessions from the borrower if the borrower misses earnings or other targets. Covenant-lite loans have no such covenants, so lenders lose this opportunity.
The trend toward covenant-lite loans is, at least, out in the open. What some find more troubling is the weakening of covenants in many mainstream first-lien loans. This is because covenant controls, along with collateral, really go to the heart of what makes a loan document unique. More to the point, covenants and collateral are the protection that lenders receive in exchange for giving up the prepayment option.
During the first quarter, the average number of covenants in first-lien loans dipped to a new low of 3.1, from 3.2 last year and from 3.6 in 2004 (this excludes covenant-lite loans). For the first time since LCD started tracking this data in 1997, the share of first-lien loans in the first quarter with one or two covenants (29%) exceeded those with four or more covenants (25%). In 2005, by contrast, the score was 28% to 33%. Private equity firms, not surprisingly, were the most aggressive in this regard. During the first quarter, the average number of covenants in a sponsor-backed loan slipped to 3.0, from 3.2 last year and 3.5 in 2004.
Of course, even with fewer covenants, a lender can have strong compliance protection. Since 2005, however, covenant cushion has been significant, giving borrowers plenty of wiggle room. LCD's numbers bear this out. Looking at LBO loans in the first quarter, the average debt-to-EBITDA covenant one year into the deal was 1.25x higher than the projected ratio in the financial model: 6.08x to 4.83x. This is up from 1.13x in 2005 and even ahead of 2004's record high of 1.22x.
Default Rates: Not Much Happening
Finally, we get to some good news for loan investors. With no new institutional loan defaults in March, the loan market's default rate inched down during the month, to 2.08% from a 24-month high of 2.09% in February. Since year-end, however, the default rate is up 0.10 percentage points (from 1.98%).
Looking ahead, most loan participants remain sanguine about the default outlook for the balance of 2006. Certainly, massive liquidity will allow issuers to continue to fix problems that might have landed them in default in more stringent times. Moreover, watch lists, by all accounts, remain short and earnings continue to grow in most sectors. The empirical evidence bears out this upbeat view. The Standard & Poor's LCD default-rate forecasting model, in fact, calculates that default rates will actually slide to 1.25% by year-end and to 1.32% over the next 12 months. This aligns with the broad consensus on the buy side that has default rates increasing only marginally this year, to perhaps 2.5%-3.0% (by number of loans).
Of course, longer term, the worry that clouds are gathering persists. Despite the welcome increase in 'BB' new-issue volume in the first quarter, the credit quality of outstanding institutional loans continued to deteriorate. The share of loans that Standard & Poor's rated 'B+' or lower grew to 55% at the end of March, up from 54% at year-end and from 42% at the end of 2004. As a result, many expect default rates to start climbing meaningfully by 2007, though a growing number of optimists out there think the market might hang in until 2008.
(Leveraged Commentary & Data is a unit of Standard & Poor's, not affiliated with the Ratings Group.)
