By Lynn Hopton and Yvonne Stevens, Co-Heads of Leveraged Debt Group, with Katy Brentz, Product Manager
We find that the leveraged loan market is much healthier today than five years ago and we continue to be constructive on the asset class.
Compared to the pre-Great Recession period, the pricing of loans today is much more reasonable in the context of credit risk and corporate fundamentals are stronger.
A robust credit review process is a key component of successful investing in this asset class.
The leveraged loan market has been on fire in the first five months of 2013, with strong investor appetite bringing down several well-established records. A massive injection of liquidity from retail mutual fund inflows and Collateralized Loan Obligations issuance encouraged more issuers to tap the market, and new institutional leveraged loan issuance posted a new record of $190 billion during the first quarter. The similarity of these numbers with those seen in 2007 has caused some investors to question if we will soon regress to the aggressively structured deal-making that characterized the pre-crisis period. Through examination of technical, valuation and fundamental factors, we find that the leveraged loan market is much healthier today than five years ago and we continue to be constructive on the asset class.
The first component investors should consider when analyzing new issuance in the loan market is institutional volume by purpose. Year to date, 65% of new loans have been issued to refinance existing debt obligations at lower borrowing costs. This contrasts starkly to the composition of issuance in 2007, wherein 64% of volumes came courtesy of highly leveraged private equity buyouts and merger and acquisition (M&A) deals. As such, most of the issuance today is essentially illusory with few new loans entering the market. This has caused the aggregate size of the institutional loan market to stagnate at around $700 billion, still a fraction of its $1 trillion-plus size at the end of 2007.
Furthermore, while a similar volume of loans have come to market, the pricing of loans today is much more reasonable in the context of credit risk. Newly issued BB/BB- loans are currently pricing at 286 basis points over LIBOR versus a spread of just 161 basis points in late 2006. Importantly, investors are receiving higher spreads at a time when the underlying fundamentals of issuing companies are much stronger and credit risk is arguably lower. We view this as a much more reasonable and attractive risk-reward tradeoff than what existed in 2007.
Expanding upon the idea of stronger corporate fundamentals, much less leverage exists broadly in the loan market today than in the months leading up to the financial crisis. This is due in part to the aggressive refinancing activity that we discussed earlier, but also to the disciplined balance sheet management that corporate executives have undertaken coming out of the Great Recession. Cash flow generation remains high and appears sufficient to allow corporations to continue servicing their debt, even if top line growth slows. Contrast this to 2007, when the fundamentals of many highly leveraged companies were beginning to display marked deterioration and ultimately lead to a default rate in excess of 10%.
In all, we continue to be encouraged by both the current income and total return prospects that the leveraged loan market offers and view the current environment as one where using an intensive credit review process that seeks to identify attractive relative value opportunities may drive performance.