Spreads for syndicated bank loans in the investment-grade market-which have been heading down for several years-may well be turning around.
Increasingly intense management of capital by commercial banks, coupled with financial pressure on Asian banks, is leading to price increases for investment-grade loans. However, pricing on non-investment-grade, leveraged loans remains under downward pressure.
This market dislocation is introducing new risks for loan investors. Careful management of these risks requires comprehensive market knowledge and intensive evaluation of the syndicated loan market overall.
Several drivers are causing the different pricing trends, including the changing mood of investors which, in the aggregate, set market pricing. In its simplest form, the historic difference between the two markets can be characterized as follows: Investment-grade investors have been relationship-oriented and less sensitive to the pricing of individual loan transactions; non-investment-grade loan investors have been transaction- oriented and more price-sensitive.
Commercial banks are currently the most important investors in the investment-grade market. These bankers have relied on the loan as a foundation for a broader corporate relationship, involving a multitude of products and services. Commercial banks often manage the profitability of the total client relationship, rather than the profitability of individual loans.
Lower loan pricing can often be offset by the revenue generated by other products, allowing banks to earn the target return on capital invested in the client. In the past, investors in investment-grade loans have accepted spread compression in syndicated loans as a cost of developing broader client relationships.
That is in contrast to the leveraged loan market, where relatively high default risk and losses mean wider loan margins. Investors in this market are very sensitive to any erosion of those margins.
Institutional investors provide an important pricing influence on the leveraged loan market. These investors do not sell other products to issuers and therefore rely solely upon loan pricing to achieve target portfolio returns. To the extent that more attractive assets are available in the capital markets, these investors may decline to purchase loans that are not priced to meet their investment return hurdles. As a result, non- investment-grade loans earn transaction-based pricing and have suffered relatively less price compression than investment-grade loans.
During 1997 the supply/demand balance that had been driving investment- grade loan pricing lower began to change. Commercial banks increased the intensity with which they managed the risk-adjusted return on capital invested to support client relationships. Investors developed financial models to evaluate the profitability of both loans and client relationships.
Some investors in investment-grade loans have concluded that these loans are priced too cheaply in this era of more intensive capital management. Many elected to either reduce their support of this sector significantly or exit low-yielding relationships.
During the fourth quarter of 1997, volatility in the global capital markets and credit concerns in Asia caused an increase in the cost of funds for many banks. The return provided by investment-grade loans became less attractive to these investors. As a consequence, loan demand is lower and pricing higher, even on relationship-oriented deals.
The future of investment-grade loan pricing and structure will be a function of numerous factors, many of which are impossible to predict. But one likely scenario is that the global investing community will require greater compensation for investing capital in relationship-oriented deals. If that scenario unfolds, a number of changes to the market will occur.
Pricing, including fees, will increase to a level which generates a target return on capital. The pressure on investment-grade loan structure will abate. New-issue volume will shift away from five-year facilities and toward 364-day facilities, reflecting the ways that many investors manage these loans for regulatory capital purposes. And total loan volume will decrease as refinancing volume falls off because of less favorable rates.
In the current environment, the market risks are greater for both issuers and investors. An issuer bringing an aggressively priced deal to the market may be surprised by the smaller bank group, and the resulting higher hold levels for relationship banks. The most aggressive issuers may elect to buy market risk from the underwriting banks, relying upon lower- cost "arranged" deals. Investors may be surprised by higher allocation levels.
As the market changes, the most sophisticated underwriters with the latest research will be the first to deliver news on the new pricing environment to issuers and investors. We believe that the successful market participants will be those that marshal the resources to manage market risks as carefully as they manage credit risks. This will require that corporate borrowers and investors stay informed, understand the changing nature of the risks in the syndicated loan market, and manage these risks very carefully.