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Leveraged loans: Can you spot the trend?

Senior Credit Analyst

Issuance continues to drop lower as high yield market bounces back after Bernanke soothed the markets

The release of the Federal Reserve’s FOMC (Federal Open Market Committee) minutes last week was able to calm the markets and bring down interest rates, though just slightly. The CDX20 High Yield Index closed 2.3% higher than the previous week, which was a significant bounce back.

Amid the high yield bond market (HYG) return, the leveraged loan market (BKLN) saw more timid conditions, with the CDX20 Loan Index closing just 1% higher than the previous week. Keep in mind, though, that leveraged loans didn’t drop as much as bonds. Read why here why leveraged loans dropped with bonds.

Loan issuance lower

Loan issuance for the week ended July 12 showed a marked decrease versus the prior week, continuing a decreasing turn. Only eight deals priced, reaching a total of $3.8 billion.

The market saw some push back for aggressively structured deals, as was the case with the Triple Point leveraged buyout loan package. The deal, structured as covenant lite 1 with a seven-times leverage. The first and second lien tranches priced at 95.5 and 94.0 OID (original issue discount), meaning that the issuers had to offer the loan at a 4.5% and 6% discount for investors to buy the deal. This is in contrast to the common recent OID values of at least 98.

Short-term weakness

While generally such a trend would spell out caution and hint that investors get bearish on the asset class, there are several factors that advocate for continued strong leveraged loan market (BKLN).

The first factor is that the structural change that has occurred, with investors pricing in the fact that at some point during the second half of 2013, the Fed’s bond buying program will taper. This should favor leveraged loans over bonds, since they pay a floating interest instead of the fixed coupon of bonds that causes bond prices to decline when interest rates rise.

The second factor is that while last week was relatively weak, the pipeline that built up after the short 4th of July week is implying strong issuance ahead. Many deals were on hold after the quiet holiday week, as issuers weren’t willing to be the first to play the price discovery game. After last week, it’s likely that more issuers will gain enough confidence to come to the market.

The third reason is that while refinancings have lost steam in the loan market, the merger- and acquisition-driven (M&A) deals are starting to gain momentum as the market gains strength. Last week, out of 24 new transactions announced, ten were M&A-related, so we should expect these deals to boost the number of deals in the near future.

  1. High yield bond–style covenants that are not tested on a quarterly basis but instead only when the company raises debt, issues dividends, or other meaningful corporate actions.

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