In 2006, the leveraged loan market rewrote the record book, piling up unprecedented volume in every category. Eleven months into the year, new-issue volume stood at $466 billion, up 58% from the like period in 2005 and far beyond 2005's short-lived record total of $295 billion. Looking at loan volume for institutional investors-–such as collateralized loan obligation managers, hedge funds, mutual funds-–new-issue volume was up an even more impressive 73%, to $314 billion.
All of this volume expanded the pool of leveraged loans held by institutional accounts to $384 billion as of early December from $248 billion at year-end 2005. The market absorbed this vast expansion with hardly a speed bump. The reason was strong demand radiating from the structured finance market where collateralized loan obligation (CLO) issuance jumped to $86 billion during the first 11 months of 2006 from $44 billion during the like period in 2006. In addition, an estimated $90 billion poured into the market from hedge funds, high-yield accounts and other nontraditional investors. As a result, spreads remained historically tight, although wide of the lows in the first quarter (see chart), and secondary prices continued to exceed par on average.
Chart 1
What's more, issuers were able to clear new loans with fewer financial covenants than they have in the past, and the volume of "covenant-lite" loans–-loans that are written with bond-like incurrence covenants rather than loan-life maintenance covenants–-soared to new heights. Also, second-lien loan jumped 56% during the first 11 months of 2006, to a record $25 billion, from the year-earlier period. In 2006, the leveraged loan market rewrote the record book, piling up unprecedented volume in every category. Through the first 11 months, new-issue volume stood at $456 billion, up 58% from the like 2005 period and far beyond 2005's short-lived record total of $295 billion. Looking at the portion of that loan volume held by institutional investors--like collateralized loan obligation managers, hedge funds, and mutual funds--new issuance was up an even more impressive 73%, to $314 billion. All of this volume expanded the pool of leveraged loans held by institutional accounts to $384 billion as of early December from $248 billion at year-end 2005.
The market absorbed this vast growth with hardly a speed bump. The reason was strong demand radiating from the structured finance market, where CLO issuance jumped to $86 billion during the first 11 months of 2006 from $44 billion during the same period in 2005. In addition, an estimated $90 billion poured into the market from hedge funds, high-yield accounts, and other nontraditional investors. As a result, spreads remained historically tight, though wide of the lows in the first quarter, and secondary prices continued to exceed par on average. What's more, issuers were able to clear new loans with fewer financial covenants than they have in the past, and the volume of covenant-lite loans--those written with bond-like incurrence covenants rather than loan-life maintenance covenants--soared to new heights. As well, second-lien loan volume jumped 56% during the first 11 months of 2006, to a record $25 billion, from the comparable period a year earlier.
A Fast Start To The New Year
Looking ahead, most participants expect first-quarter 2007 to bring more of the same. Robust CLO issuance will ensure demand is strong, by all accounts. And on the other side of the ledger, volume will undoubtedly get out of the gate quickly, as arrangers launch a backlog of long-expected jumbo deals, including those of Kinder Morgan Inc. (BBB/Watch Neg/A-2), Univision Communications Inc. (BB-/Watch Neg/--), and Clear Channel Communications Inc. (BB+/Watch Neg/--).
That the good times are expected to keep rolling in the leveraged-loan market is a tribute primarily to the benign credit cycle. Indeed, the loan default rate dropped to 1.15% in November 2006 from 1.98% at 2005 year-end. This defied the forecasts of most participants, who had generally expected defaults to trend higher in 2006 because of more leveraged capital structures in the leveraged-finance universe.
Strong earnings momentum, of course, has been the primary driver. During the first half of 2006, EBITDA grew 15% at issuers that filed publicly in the Standard & Poor's/Loan Syndications and Trading Association (S&P/LSTA) index. Strong liquidity, too, has kept default rates low, allowing issuers to stave off default via covenant waivers or outright refinancings. So far this year, "Leveraged Commentary & Data News" has reported on 31 issuers that have taken the former route, while Resorts International highlights those that followed the latter path. This issuer took out its stressed term loan (then rated 'CCC+') with a commercial mortgage-backed securities (CMBS) offering. Lastly, and in some ways ironically, the weaker covenant packages have also given many issuers breathing room. This has pushed some potentially difficult situations down the road.
The empirical data continue to flash signals that, taken together, suggest default rates will trend higher in 2007 but remain inside the historical average of 3.37%. This, not coincidentally, lines up with the consensus among loan portfolio managers.
On the positive side, market distress remains nonexistent. As of November 2006, not one performing loan in the S&P/LSTA index is trading at 70 or lower. Looking at ratings, however, the story is less persuasively bullish. The percent of loans that Standard & Poor's rates 'CCC+' or lower stood at 2.59% at the end of November, down from 2.79% in October but still the second-highest reading in three years. However, it's not far from the 2005 average of 1.48%. The Standard & Poor's default rate model gives further testimony to the belief that defaults will increase gradually in 2007. By November 2007, the model calculates, the rate will climb to 2.61%.
The Big Story: Loans Led 2006 Leveraged Finance Issuance
Sought after by investors and issuers alike, loans now dominate the new-issue market for leveraged finance as never before.
Leveraged loans hold a commanding 78% share of the total $587 billion of loans and high-yield bonds that cleared the new-issue market in 2006, up from 72% in 2005.
Turning to the debt held outside the banking system--institutional loans and high-yield bonds--the story is the same. The share of loans in this segment of new-issue volume was 72% for the first 11 months of 2006, or $290 billion of $406 billion, up from 68%, or $165 billion out of $246 billion, in the year–earlier period.
As a result, institutional loans grew to 36% of the overall universe of institutional and high-yield bonds by the end of October 2006, or $341 billion out of $938 billion, from 28% at year-end 2005 and from 25% at the end of 2004, based on loan data from Standard & Poor's Leveraged Commentary & Data (LCD) and bond data from Merrill Lynch high-yield research.
Why Loans Are So Popular
Issuers--particularly on the private equity side--have embraced loans for a number of obvious reasons, including:
The prepayment option--a handy choice, for sure, in this age of rapid flips and dividends;
Loan covenants becoming less and less restrictive, making them more appealing to leveraged issuers;
The second-lien loan juggernaut allowing private issuers to "layer in" subordinated debt that isn't issued in the bond market and to leverage up their balance sheet while avoiding the tedious SEC disclosure process;
The amortizing term loan becoming an anachronism--except when deals get so large, as with HCA Inc. (B+/Negative/--), that issuers are forced to tap banks. This means issuers can go with a loan package and still largely avoid principal repayments. In 2006, just 5% of LBO loans had an A tranche, down from 8% last year and 13% in 2004. Back in 2001, 75% had an A loan; and
Tight loan spreads, and, thus, low absolute borrowing costs, even with today's inverted yield curve. Take HCA's recent transaction. The issuer will pay 7.75%-8% on its institutional loans at LIBOR+275. The second-lien bonds, meanwhile, are printed at 9.125%-9.625%.
On the other side of the supply/demand continuum, the inverted yield curve is clearly a plus for loans among retail investors, who put $4.6 billion in net new money to work in loan funds during the first nine months of 2006 (according to Lipper, a Reuters company) while withdrawing $3 billion from high-yield funds (according to Affiliated Managers Group Inc. (AMG).
Where The Money Is
In the grand scheme of things, retail money is chump change. Structured finance is where the real money is, and here loans are preeminent. High-yield bond vehicles (CBOs), on the other hand, have never recovered from the drubbing they handed investors in the early 2000s. The statistics are unambiguous. During the first 11 months of 2006, CLO issuance soared to $86 billion, easily topping the prior high of $52 billion in 2005, according to JP Morgan CDO Research, Merrill Lynch structured finance research, and Standard & Poor's CDO Chief David Tesher. The volume of CBOs backed by high-yield, meanwhile, was just $345 million, JP Morgan reported.
This is not to say that the high-yield market lacks liquidity. HCA's recent $5.7 billion offering famously flew off the shelves and broke into the secondary market, priced at 103.5. What's more, the even larger Freescale Semiconductor Inc.'s (BB-/Negative/--) $5.9 billion offering also blew out at tighter-than-expected levels. More broadly, the high-yield market has rallied in recent months on the strength of low defaults and strong demand from hedge funds and institutional accounts. LCD's bond flow name composite illustrates the point. The average flow name bid as of Oct. 16, 2006, stood at a five-month high of 100.11, up 216 basis points since the end of September.
Despite this strong appetite for bonds, arrangers expect issuers' love affair with loans to go on. If anything, the healthy bid for bonds has generated additional demand for loans from crossover investors on deals such as HCA, Freescale, and Rental Service Corp. (B+/Stable/--)
And certainly, it's hard for issuers to resist the generous terms that loan accounts are offering. Moreover, some arrangers speculate that in order to compete, bond investors might eventually be forced to give ground on some sacred cows, such as strict call protection.
By any measure, 2006 was a terrific year for the loan market. Volume climbed to record levels in nearly every category, while default rates remained low. Most participants expect more of the same in 2007, with new-issue volume rising further still and a combination of robust liquidity and earnings growth continuing to insulate the market from a default spike. Still, with our models flashing warning signs, an uptrend in default rates shouldn't come as a big surprise to any keen observers of the market.
(Leveraged Commentary & Data is a unit of Standard & Poor's, not affiliated with the Ratings Group.)
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