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Thursday, January 15, 2009

The Corporate Loan Conundrum

Here's our two cents worth on the year-end state of the leveraged loan market, and a little insight into the challenges that lie ahead.

First off, 2008 was a tough year for corporate loans. Among leveraged loans, we saw roughly 4.5% to 5% defaults for the year, heavy pricing declines (the S&P/LSTA U.S. Leveraged Loan 100 Index was down roughly 30% in '08) and with them low recoveries, due, among other things, to the supply/demand problem and pessimistic perceptions for the economy.

(Worth pointing out was a slight uptick in the second half of December. Was this a bottoming out? A false bottom perhaps? Some high-level executives and managers are vocal about current spread levels being at or near their highs, and that we're due for some tightening in 2009. See for example Creditflux's Viewpoint: Looking for the bottom; but are they talking their book, and do we really have a good feeling for the duration of loans in this low, slow prepayment environment?)

An Issue of SUPPLY (and demand)

Demand is so small is deserves only a side mention; supply is the elephant. Why?
  1. Fund (incl. hedge fund) liquidations and forced selling, to meet both investor redemption requests and (particularly variation) margin calls
  2. Selling by banks to decrease leverage
  3. Overhang of unsold loans (incl. bridge loans) on syndication desks' balance sheets that the banks were no longer able to securitize due to the severely diminished CLO juggernaut, a previously major source of demand for broadly syndicated loans
  4. Demand by existing CLO managers has decreased too:
  • low prepayments on current loans in the portfolio mean less available principal to reinvest
  • loan downgrades have resulted in many CLOs maxing out on their CCC-rated buckets (which in turn limits managerial flexibility in trading new loans)
  • historically low loan prices mean that investments in these loans are reflected as "deep discount" purchases for overcollateralization test purposes

What the future holds for loans and CLOs

Corporate loans weren't highly traded, relative to bonds, say, prior to the onslaught of CLOs (which steadily gained steam from 2001 to early 2007). S&P/Markit/Reuters' move towards a CUSIP identifier (from LoanX, LN numbers) may prove of minor assistance to the liquidity situation, but this will take a while.

The prospects are dim for 2009: large supply and high defaults are typically accompanied by low recoveries, a dual burden (see for example Longstaff, Schwarz's "A Simple Approach to Valuing Risky Fixed and Floating Rate Debt").

As this relates to CLOs: as defaults continue to plague corporations and deals continue to fill their CCC buckets -- and then have excess CCC assets haircut at market value (not recovery rate) for overcollateralization test purposes -- more CLOs naturally begin to trip overcollateralization triggers on a weekly basis, causing cashflows to be directed from the junior tranches and residual pieces towards paying down senior note holders (reducing the duration of the latter).

Similarly detrimental is the fact that most CLOs ramped up their loan portfolios during a credit cycle marked by the particularly high levels of liquidity it generated and the low defaults exhibited. The resulting strong demand created the opportunity for debt issuers to obtain low coupons on their debt despite weak covenant packages. Strong covenant packages typically reduce a company's cost of debt and, importantly, protect debt investors from wide negative swings in the value of their investment. (In sum, relative to a company's overall investors, weak debt covenants are arguably equity-friendly for the company, and debt-unfriendly.) See also The Luxuries of a Covenant Light Lifestyle.

The optimistic view is that this can all change quickly if we begin to see sufficient buyer power at these distressed levels. If some of the distressed funds decide that the opportunities lie in loans, and the bigger loan/asset managers (PIMCO, Babson, TCW, Blackrock) start putting their money to work, loan prices could rebound even on thin volumes and the deals which have benefitted from decent excess spread generation over the last 4 to 5 years during the low default environment may survive some of the pending difficulties. Certainly we're optimistic that many, if not most, of the AAA tranches will come out whole in this scenario, but whether the AA or single A tranches survive or suffer principal losses may differ from deal to deal, and may depend on the remaining length of each deal's reinvestment period, among other things.

While we fear the worst, we're long optimism.

1 comment:

Anonymous said...

This is good. Everyone is caught up in the price of loans, and not the value.