Features : A Borrower's Market
Yield-hungry investors are piling into a market that offers high returns, reduced risks and a degree of inflation protection.

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The success of the leveraged loan market in 2005, when lending exceeded $500 billion for the first time ever, has brought it to the attention of the broader financial community. Many observers have declared that leveraged loans are now a mainstream product, and some have talked of leveraged loans usurping the high-yield bond market as a financing tool.

While the leveraged loan market—essentially shorthand for below-investment-grade loans with most issuers being single- or double-B rated—may have only begun garnering headlines in recent years, it is a well-established market. It became a significant product as early as the mid-1990s, and use has grown steadily since then.

But a combination of factors—including strong mergers and acquisitions volumes, increased private equity activity and a growing appetite among institutional investors—combined to significantly increase volume in 2005. Observers estimate that the market was worth $570 billion in 2005 compared to around $480 billion in 2004. In contrast, the high-yield market generated less than $100 billion in new issuance in 2005.

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“The market now has the depth to absorb a number of huge deals.”

“The preponderance of large deals was one of the most notable elements in the record volumes of 2005,” says Dan Toscano, head of loan syndication, Americas, at Deutsche Bank in New York. “The market now has the depth to absorb a number of huge deals; there were 32 deals of over $1 billion last year, compared to 20 in the prior year. That simply wouldn’t have been possible in the past.”

Among the mammoth deals of 2005 was the $4 billion institutional-investor-targeted loan for financial information company SunGard Data Systems in a leveraged buyout worth $12 billion in July. In December the $3.85 billion loan package for the $15.1 billion leveraged buyout of vehicle-rental company Hertz Corporation also demonstrated the huge capacity of the market to absorb new issues.

Bankers say so many investors are lining up to invest in the leveraged loan market that it is hard to imagine what size of deal would be prohibitive to success. “One of the primary problems we have is the number of investors that want to be in this market,” says Tom Newberry, head of the syndicated loan group at Credit Suisse in New York. “Every week we have new people calling up to tell us they’ve entered the market and would like to be allocated paper.”

Expanding Issuer and Investor Requirements
Issuance in the leveraged loan market comes roughly equally from two main sources: corporates and financial sponsor activity. Issuance derived from financial sponsors—used to take a company private, conduct a leveraged buyout or finance a dividend to shareholders—has increased sharply in recent years and helped to drive change in the market. “The private equity community has a great deal of money to put to work in acquisitions, and therefore their requirement for loans is expected to grow,” says Newberry.

Corporate borrowers, which use the leveraged loan market for a variety of reasons—including funding acquisitions, capital expenditure or refinancing existing debt such as bonds—have also increased issuance as general corporate activity such as M&A has grown. “Many corporations are relatively liquid and have consequently turned their attention to expansion either organically or through M&A. That again increases appetite for leveraged lending,” Newberry explains.

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“Leveraged loans simply add to the choices available.”

The increased activity in leveraged loans has led to claims that it has replaced high-yield bonds as the market of choice for capital-hungry companies or cost-conscious private equity players. But Andy O’Brien, head of US loan syndication at JPMorgan in New York, says that it is not an either-or choice for issuers between the two markets. “They tend to be done in tandem, especially for leveraged acquisitions,” he says. “The markets offer different products for different situations, and leveraged loans simply add to the choices available.”

The benign economic environment of low interest rates and low bankruptcy rates has been central to the growth of the leveraged loan market. But the massive growth of investor funds entering the market has compounded the attraction of the leveraged loan market for issuers by driving down costs. “This is an exceptionally issuer-friendly market, and there appear to be no signs that it will end,” says O’Brien.

Investors are drawn to leveraged loans for a number of reasons. Yields in the market have become increasingly attractive on a relative basis compared to high-yield bonds. In 2005 average returns on leveraged loans were over 5% versus around 5% in the
high-yield market, which carries more risk. While such performance is an anomaly—absolute returns are almost always lower in leveraged loans—it served to highlight the opportunities available in leveraged loans and brought new investors to the market.

Low Volatility, High Returns

Even if the returns of leveraged loans and high-yield bonds revert to their historical levels, leveraged loans are likely to remain in favor, especially among hedge fund investors, for other reasons—principally their low volatility of the asset class compared to high-yield bonds or other debt instruments. “Low volatility creates opportunities for investors such as hedge funds to increase leverage,” explains Toscano. “It means that they can, for example, raise $100 million of equity, leverage it eight times and have $800 million worth of buying power and income-generating capacity. Even after the leverage has been serviced, it can be possible to generate returns in the mid-teens or better with this strategy.”

As another banker notes: “Banks are falling over themselves to lend money to leverage investments in the loan market. If returns fall in the market, greater leverage will simply be used to get returns up to an acceptable level again. Alternatively, attention will simply be switched to the higher-yielding but more subordinated second-lien market.”

Already, interest in second-lien loans, which are lower in the capital structure but carry a higher coupon, has soared. “People are hunting for yield, and second-lien issuance has been the beneficiary of that,” says Newberry. “While most of the early second-lien deals were sold to hedge funds, they are now frequently being sold to accounts that traditionally would have only been first-lien lenders.”

At the heart of the attraction of investors to leveraged loans is the market’s resilience in tough times. “What is very striking about the leveraged loan market is the low default rate and, more importantly, the high recovery rate in the event of default versus the high-yield market,” explains O’Brien. “If we do enter a more difficult credit cycle in 2006, as some people expect, those characteristics are likely to make the leveraged loan market even more attractive for investors.”

Most observers believe that the credit cycle will begin to change in 2006, although any major increase in default rates is unlikely before 2007. The normal default rate for leveraged loans is around 3%, but in recent years defaults have averaged around zero percent to 1.5%. “It will be interesting to see how the market reacts to the increased defaults,” says Toscano. “Last time there was a low point in the credit cycle, the market was not dominated by institutions but by banks. Necessarily, there will be a difference this time around.”

“Money managers and pension fund managers are now—along with collateralized loan obligation [CLO] managers—buying up to 60% of these loans,” says O’Brien. CLO managers buy up leveraged loans to repackage and sell as securities issued against a wide pool of loan assets of different quality.

Meanwhile, another characteristic of leveraged loans that should stand the market in good stead is that they are floating-rate instruments. They should become relatively more attractive to investors as interest rates rise because fixed-rate instruments such as high-yield bonds will fall in price while floating-rate instruments will not.

The anatomy of a leveraged loan

The first-lien leveraged loan market is senior secured—the top of the capital structure—and is floating rate, being priced off Libor (London Interbank Offered Rate). Loans are usually callable—pre-payable at par—and also come with covenant packages offering investors greater security. Generally, leveraged loans have maturities of up to around eight years.

 

 

In contrast, most high-yield bonds are subordinated in the capital structure, offer little or no covenant protection and often have maturities up to 10 years.


A first-lien leveraged loan is typically broken into two tranches: a pro-rata or A-term loan, which is sold largely to banks, and a B-term loan, which is bought by institutional investors. The two tranches typically are rated the same but have different yields and average life.


The B tranche is usually longer in duration and constructed so institutional investors get most of their payment for the loan toward the end of the term of the loan. This simplifies their investment profile and reduces re-investment risk caused by assets maturing early.


The second-lien leveraged loan market has been growing apace in recent years. These loans typically rank one or two notches behind the first lien in the capital structure—so they are more likely to be hit in the event of a default—and have higher coupons. While such instruments were used primarily as rescue financing in the past, the continuing reduction in borrowing costs across the board have made the second-lien market more attractive to issuers while still offering value to investors relative to first-lien loans or high-yield bonds.


“The second-lien market can be used as a bond proxy for issuers that either don’t want to, or aren’t in a position to, file the financial statements required by the market,” says Tom Newberry, head of the syndicated loan group at Credit Suisse in New York. “It is also possible to do second-lien deals that are smaller than what the market will traditionally accept, and they can offer greater flexibility in terms of call structures.”


Threats on the Horizon?

The weight of money in the market and investors’ quest for yield continue to increase the scale of deals that the market will take and reduce the costs at which they can be financed. Nevertheless, it will be difficult to match or surpass the $570 billion issued in 2005, says O’Brien. “A lot of the money raised in 2005 was refinancing of existing leveraged loans, which will not now come due for many years,” he says. “However, there will be a continued trend toward larger deals, and activity from private equity could increase issuance further.”

Toscano agrees that the growing war chest being amassed by private equity firms for leveraged takeovers means that the demand for leveraged lending to facilitate investment will be huge.

“The feeling is that there are now no companies off limits for taking private,” he says. “And that can only mean a greater number of larger deals will come to market.”
 

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