Trading of Leveraged Loans in Secondary Markets Nears Record

Leveraged loans are changing hands in the secondary market at a record pace,  the Loan Syndications and Trading Association says.

The aggregate loan volume of $391 billion through the first nine months of 2013 nearly equaled the full-year 2012 total, according to an LSTA study. "We should hit $521 billion” by yearend, said Ted Basta, vice president of market data for the association. That would exceed 2007’s level of $519 billion, the current record high from the second year the LSTA began tracking secondary-volume data.

In addition the turnover ratio of leveraged loans – a measure of market liquidity tracked by dividing trading volume by the average size of the broadly followed S&P/LSTA Loan Index – is on track to surpass 70% for the first time, according to Basta.

The quarterly report is based on trade data from the 21 largest buy-side and sell-side member firms. Information on secondary trading of noninvestment grade corporate loans is scarce, and the study is one of the few sources of aggregate data on the market.

The pickup reverses what has been a five-year decline in secondary market volume and turnover ratios. In a Nov. 8 U.S. Credit Alpha report, Barclays noted that this decline between 2007 and 2012 coincided with a decline in new issuance. The firm attributed those slowdowns to concerns about the viability of the market for collateralized loan obligations, which are big buyers of loans, as well as concerns about looming 2014 maturities, which it said fueled significant bond-for-loan refinancing activity before this year.

What’s changed? In the first nine months of 2013, issuance of CLOs surged, fueling demand for new and existing loans alike. Barclays translated the resulting rise in primary market volume to significantly improved secondary market volumes. Some $57.1 billion of CLOs were issued in the first nine months of the year, according to Fitch Ratings.

The pace of issuance has slowed in the second half of the year, since new rules governing bank deposit insurance took effect. Banks were once among the biggest buyers of the triple-A tranches of CLOs, but these securities are less attractive under the new rules. Nevertheless, CLO issuance has already surpassed the full-year total of $51.9 billion for 2012.

At the same time, expectations that interest rates will rise boosted demand for loans which, unlike most bonds, are floating rate. This allowed companies that are below investment grade to refinance, pushing maturities further out.

CLOs, along with mutual fund investors, are the driving force behind a $100 billion surge in loans outstanding on the S&P/LSTA Loan Index this year, LSTA officials say. Through the end of September CLOs were the top investing asset class at $67 billion, or 52% of the market share (which is predominantly in secondary-loan investments), followed by $57 billion from loan mutual funds.  

“Between the mutual fund increase and the CLO increase, there’s $124 billion of additional liquidity in the loan market,” said Bram Smith, executive director of the LSTA.

Besides CLOs and mutual funds, “you [also] have different distressed and high-yield accounts coming in, looking to hedge that rise in interest rates,” Basta said. “Pension funds are definitely more interested in the asset class than we’ve ever seen before, and I think that has a lot to do with the low duration levels, when you compare that to other asset classes.”

A quarterly breakdown of trading volume shows that $121.3 billion of loans changed hands in the third quarter, down from $150 billion in the second quarter but up from $119.637 billion in the first quarter.

An early look at fourth-quarter volume figures indicates that the record pace is continuing, if not accelerating, Basta said. “Based on what I’ve seen, we had a tremendous October, the second-highest total for the year on a monthly basis,” he said.

The 70% turnover rate projected this year for loans in the S&P/LSTA Leveraged Loan Index is also an indicator of high demand from secondary-market investors, according to Basta. Such a turnover ratio on the index would top the high mark from the precrisis 2007 level of 68% and far exceed the 2012 turnover ratio of 58%. The low mark since 2007 was 51% in 2010.

Volatility and pricing have remained steady in the secondary market, according to Basta. Over the last four months, the LSTA has tracked median prices of loans trading at par and an eighth (or within 0.125 basis points of the issue price). “If you look across all trading volume over the last nine months, over 80% of all our volume is on loans trading at a price greater than 98 cents on the dollar,” said Basta. “The technicals are good, fundamentals are good, and the secondary market’s been chugging on irrespective of the volatility we’ve seen in high yield, equities, etc.”

Market breadth and depth is also performing solidly, with 23% of loans trading more than 20 times per month, and about 50%t trading less than 10 times monthly. The LSTA also tracks pricing performance through the LSTA/Thomson Reuters LPC Mark-to-Market Price Accuracy study, and Basta said over the past seven quarters, the median differential between trading and mark-to-market prices has remained below 25 basis points.

“On a historical level, you have to go back to 2006 where the all-time low differential was 16 basis points,” Basta said. “But back then, the market was trading an average price above 100, and today it's 98. If you take into context the trade price level, and the accuracy level, today’s prices are far more accurate.”

This story originally appeared in Leveraged Finance News