Loan Issuers Flex Their Muscles While They Can

Issuers of leveraged loans are in the driver's seat — for now.

Though both supply and demand on the primary market have increased, demand has outpaced supply because investors are more confident and market trends are strong.

As such, price flexes are more often heading downward, with the interest rate spreads on $10.2 billion of deals tightening since mid-January, while only $4.2 million widened, according to Thomson Reuters. Translation: the issuers, typically large corporations, are paying less to borrow money and investors are earning less as a result.

In addition, issuers are pushing the envelope, with leverage as high as 7x popping up on broadly syndicated loans.

"Pricing is pretty thin," one loan investor said. "For the risk, it may still be fair, but there certainly isn't a lot of extra fat on the yield. You're cutting it pretty tight for the borrowers' benefit."

After the market turmoil that began in August pushed the average loan new-issue yield to more than 8%, it has now fallen to roughly 6%, where it sat in January 2011, according to Standard & Poor's LCD. And there are plenty of higher-rated credits coming in at around 4%. Further illustrating the lack of supply on the primary market, the average institutional bid for most actively traded secondary loans has climbed to around 98, roughly where it was a year ago, after plummeting to nearly 88 in August and vacillating in the low 90s through the fall.

Market participants expect supply to pick up, with buy siders reporting that the trickle of deal proposals coming from the banks is slowly growing into a stream, albeit few transactions are cracking the $1 billion mark.

"We're pretty busy," said a New York-based banker.

A rise in opportunistic deal announcements and U.S. loans from European issuers pushed the forward calendar to $15.7 billion on Feb. 1, from $5.1 billion at year-end, according to S&P LCD. However, on the flipside, the schedule of visible loan repayments grew to $12 billion as bond takeout activity surged.

In short, it will take time for supply to catch up with demand, with most market participants looking to the second half for volume to trend higher, barring any macroeconomic shocks.

In the interim, expect interest rates to flex downward. One of the most recent, and larger, transactions to tighten is the $1.05 billion term loan B for EMI Music Publishing, a deal led by JPMorgan Chase & Co. that supports the company's acquisition by Sony Corp. The issuer cut the interest rate by 50 bps, to Libor plus 425 bps, and decreased the discount to 99 cents on the dollar from 98.5 cents.

And acquisition deals are not the only ones flexing down. Earlier this month, the $305 million term loan B backing a refinancing/dividend recap for Focus Brands, led by Credit Suisse, also tightened by 50 bps, to Libor plus 500 bps, while the discount came in to 99 cents on the dollar from 98.

There are other signs of demand for paper. Every time since mid-January that a borrower has lowered the interest rate and offer price on an institutional loan, the loan has subsequently risen in the first day of trading on the secondary market, according to Markit.

"For deals that have flexed down, we're seeing them come in above the [original issue discount], at par or higher," said Otis Casey, director of credit research at Markit. "This indicates strong follow-through demand for these loans."

The Focus Brands refi/dividend deal, for example, which priced with an original issue discount of 99, closed its first day of trading, Feb. 22, with an average bid of 100.125. Of those recent deals that have tightened, the loan with the largest gap between its offer price and closing bid the first day of trading is the $660 million acquisition loan for Prestige Brands International. That deal, priced at Libor plus 400 bps, allocated with an OID of 98.5. Its average bid at closing on its first day of trading, Jan. 30, was 100.5.

Underlining the fact that investors are bidding up loan prices in the secondary market: The 31 closed-end loan funds tracked by Lipper returned an average 4.03% for the year through Feb. 21.

All that said, some of the higher-rated, lower-priced loans, those with spreads in the neighborhood of Libor plus 300 bps, with a 99 offer price, have later traded down, one trader said.

"They traded OK initially, but now they're definitely off highs," this person said. "I'd say for a week we've been about sideways to a bit lower. The stuff yielding 4%, they've been drifting from par back down to mid-99s or lower-99s… . I don't think they're going to go really low, because most of those companies are pretty well rated. But people are looking for higher coupon stuff."

The stabilization of the macroeconomic environment is the key to supply increasing, and as of now, the outlook appears fairly bright. Unemployment remains at a four-year low, corporate cash is at historically high levels, Greece appears to have a plan and even sales of existing homes have increased.