Those of us who have participated in-or in our case observed-the leveraged loan market over the past several years have witnessed one of the ironies that characterizes the growth of most financial markets. When in their infancy, markets offer substantial premiums to those intrepid investors willing to provide capital. Over time, this illiquidity premium is recognized, and the market begins to draw more and more professional investors. Ultimately, the growing investor base drives out some or all of this premium that helped to make the market attractive in the first place.
In recent years, the leveraged loan market has developed from a closed, virtually bank-only market to a thriving segment of the capital markets. This evolution has been driven by the rapid growth of the institutional loan investor base - which stood at over 60 at yearend-and the secondary loan trading market.
Soaring investor demand has forced credit spreads down. It is easy to misinterpret the extent of this deterioration, however, by looking only at large, high-profile loans that have become highly liquid in recent years. Banks and institutional investors have accepted lower spreads on these loans in exchange for the ability to better manage concentration risks. By comparison, credit spreads on smaller, less-liquid loans have declined far more modestly.
This conclusion is demonstrated with a simple analysis of pro rata tranches-revolving credits and amortizing term loans-for acquisition- related loans tracked by Portfolio Management Data. The average credit spread of loans in this sample that are at least $500 million, presumably the most-liquid loans, declined 44 basis points from 1995 to 1997. This compares to a decline of just 20 basis points for loans of $100 million or less. The more pronounced decline in pricing for larger loan reflects, in part, lenders' willingness to trade off a lower credit spread for improved liquidity.
A similar story can be seen in the pricing of institutional term loans. The institutional term loan market was developed in the early 1990s as a way to carve out longer-dated term loan maturities for investors who were more willing than banks to take on term risk. Until 1995, the ranks of institutional investors were so thin that issuers had to pay a premium of 50 basis points over the credit spread of revolving credits and amortizing term loans.
Since 1996, however, increased participation by institutional investors has allowed the premium to narrow significantly with the largest declines for loans of $500 million or more. The gap between pro rata and institutional pricing during the final quarter of 1997 narrowed to 31 basis points for loans of $500 million, with the vast majority at a 25-basis- point difference. This compares to an average gap of 43 basis points for loans of $100 million or less.
The effects of liquidity on-and the increasing efficiency of-the leveraged loan market can also be seen in the secondary market. In the fourth quarter of last year, loan supply picked up dramatically, particularly in the institutional term loan market, where volume reached a record of roughly $14 billion-more than twice that of the prior quarter- according to Loan Pricing Corp.
As a result, pricing backed off significantly in the secondary loan market, where the average bid for institutional term loans declined roughly 25 basis points, to just under par. This is the first time that the average bid for these loans has fallen below par since mid-1996, according to Donaldson, Lufkin & Jenrette. This was partially driven by investors selling off to make room for new deals.
The recent backup in the secondary market notwithstanding, the leveraged loan market continues to attract institutional money. Just last quarter, two equity sponsors raised funds that invest in bank loans and high-yield debt. This increased institutional involvement-along with the growing liquidity that it brings-seems likely to reduce whatever illiquidity premium is left in the leveraged loan market.
