Sunday, August 24, 2008

Risk-Taking Hits Investors In Leveraged-Loan Market - WSJ

Leverage buyout boom loaded many companies with substaintial debt. As economy slows down, they are hitting the wall. The default rate is on the rise, exceeding that of junk-bonds that is usually considered riskier. Furthmore, the recvery rate is expected to be worse than norml, though higher than that of junk-bonds, due to the riskier composition of the market: more second-lien loans, convenate lite loans, and loan-only....

There's nothing like a bad bust to make investors regret a good boom.

The feeling is particularly acute in the leveraged-loan market, where during the bull years of 2006 and early 2007, investors felt emboldened to take on excessive risk.

As a result, the rate of defaults -- instances where a company is unable to make its interest payments or meet the obligations in its debt agreements -- is higher in the loan market than it is in the junk-bond market, which has traditionally been perceived as the riskier of the two markets. To make matters worse, investors stand to recover less in leveraged-loan defaults than what was historically normal because of the riskier composition of the market.

"What that tells you about is the tremendous amount of poor quality financing in the easy money period of 2004 to 2007 and now, when the economy slows down, these companies have way too much debt and they're hitting the wall," Margie Patel, portfolio manager at Evergreen Investments, said. "It also tells you why loans have been trading, in general, at a substantial discount to face value."

The average price in the loan market is around 88 cents on the dollar these days, according to Standard & Poor's Leveraged Commentary & Data unit, down from above 100 cents before the credit crisis.

During the boom, it wasn't uncommon for companies to bring their entire debt package to the market in the form of loans rather than split between bonds and loans. That means some of the riskiest debt, which normally would have been issued in the bond market, is now part of the loan market.

According to S&P's LCD unit, these "loan-only" deals account for a much larger percentage of defaults in the market than in prior years. Of the 25 defaults in 2008, 44% were for companies that didn't have bonds, whereas before 2008, that level was around 12%.

"As the current credit crisis unspools, the loan market's glorious past as a default underachiever might well be history," Steve Miller, managing director of S&P's LCD, said in a research report on the topic. "That's not to say that loan defaults are likely to leapfrog bond defaults. More probable, leveraged loan and high-yield bond defaults seem likely to track more closely in the future than they did in the past."

The trouble is that on top of rising defaults -- the rate in the loan market is currently around 2.92% whereas it is 2.37% for bonds according to S&P -- the prevailing expectation is that recoveries postdefault are going to be lower than they used to be. That is the result of the extra risk-taking investors were partaking in before the blow-up.

Meredith Coffey, senior vice president at the Loan Syndication and Trading Association, points to a number of reasons that recoveries will be lower. Investors allowed companies to issue loans that were less secure, known as second-lien loans. They also accepted fewer protective provisions on loans that became known as "covenant-lite." Investors also allowed companies to add very heavy debt burdens to their balance sheets.

"I think people do expect the loan recovery rate will be lower than historical norms," Ms. Coffey said. "But if you look in the context of high-yield bonds, the expectation is still that loan recoveries are much higher than high-yield bonds."

That's some reassurance for investors, yet hardly enough to keep them from bidding up the price of loans, which are hovering around historic lows. Even in the market meltdown of 2002, the average price of loans remained above 95 cents on the dollar, according to S&P.

Market participants expect that this default cycle will prompt companies and their underwriters to retrench and come back to the market with debt deals that more closely represent the deal-making done before the recent boom, meaning companies will have bonds subordinated to loans, stricter covenants on their loans and lower debt burdens overall.

In this market, the future means a return to the past. Yet the loan and bond markets have already lived through a buyout boom and bust where risk-taking like this was to blame. The question is whether market participants will learn enough from this bust to prevent the cycle from repeating itself again after this credit crisis is over.

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