A Risky-Loan Market Is Back in Gear
Leveraged Debt, Part of the Credit Bubble, Attracts Yield-Hunting Investors; Not as Frothy as '07.
By MARK GONGLOFF
One of the markets at the heart of the credit bubble has surged back with surprising speed as investors chasing yield are increasingly willing to finance riskier companies.
.Poster children of the mid-2000s credit bubble, leveraged loans are set to have their busiest year since 2008, thanks to a rush of money into the market from investors looking for high-yielding alternatives to stocks and junk bonds. It is a boon for speculative-grade companies looking to refinance and for private-equity firms hoping to start a buyout wave.
But just as the market has sprung back from its depths, so too has the relative riskiness of many loans. Investors are letting companies take on more debt relative to their cash flows and use the proceeds for creditor-unfriendly activities like paying dividends to stockholders.
Though the market is nowhere near as frothy as in 2007, some of these loans could suggest investors will make riskier bets to attain higher-yielding assets, despite the economy's wobbles.
"I wouldn't be so surprised by some of these deals in a normal environment, where we were growing steadily or recovering in a fulsome way, but we're not," said Peter Cecchini, chief strategist and head of special situations at BGC Capital.
Through May, the bulk of loan issuance was refinancing old debt. But the balance is beginning to shift, with nearly a quarter of all deals since June being used for leveraged buyouts, such as those of Burger King and Interactive Data Corp., up from just 10% earlier in the year, according to data from Standard & Poor's Leveraged Commentary & Data Group. Merger, acquisition and leveraged-buyout activity makes up 47% of the market, up from 29% earlier this year.
That percentage will likely grow, given the number of deals bankers see in the pipeline. The surge in activity is striking considering the losses investors had in the sector in recent years.
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Loans are Cheap to Default Risk. Access thousands of business sources not available on the free web. Learn More .Meanwhile, a number of companies, such as pharmaceutical maker Warner Chilcott, are tapping the loan market to pay dividends. Fixed-income investors often frown on such activity because the company ends up saddled with more debt, hurting lenders while rewarding stock investors. Warner Chilcott's leverage ratio is still relatively low, and Moody's recently upgraded its debt, citing strong cash flow.
In a sign the market hasn't returned to its old ways, investors recently thwarted CVC Capital Partners' attempt to borrow to pay a dividend, arguing it would have piled the company's debt burden too high.
Debt burdens are rising for many borrowers. One key measure of a company's debt burden is the ratio of debt to earnings before interest, depreciation and amortization, or Ebitda. Known as the "leverage ratio," this offers a rough measure of how easily a borrower can pay debts.
At the peak of the 2007 loan-market frenzy loan issuers carried leverage ratios above eight times Ebitda, said Andy O'Brien, co-head of syndicated and leveraged finance for J.P. Morgan.
.Leverage ratios of firms borrowing today aren't that high, but have risen. Recent deals have had leverage ratios of six times Ebitda or more, up from a low of four in 2009, noted Mr. O'Brien. "The difference in this recovery is the speed with which leverage has returned to the system," Mr. O'Brien said. "What took years to recover in prior cycles is only taking months this time."
For now, investors still have the balance of power. Trading at less than 93 cents on the dollar in the secondary market, up from a low of 63.5 cents in 2008, loans remain cheaper than junk bonds at 99 cents, said S&P. The typical loan can yield up to 5%, depending on its base floating rate—less than a high-yield "junk" bond, but with more protection for investors because loans get paid before bonds in a bankruptcy.
Demand for new loans has been steady, and recent deals have been so hungrily received that they have been able to cut their yields or bolster their size.
"In lots of markets, demand creates supply," says Steve Miller, head of the S&P leveraged-commentary group. "These issuers have all wanted to do loan transactions for a while. The demand is there now, so they're putting deals out there."
Some $319 billion in leveraged loans have been marketed in the U.S. this year, by companies from American International Group to United Health Services, said data firm Dealogic. It was $173 billion this time a year ago. The market is on track to be the busiest since at least 2008.
Loans have returned 6% this year and nearly 43% since the end of 2008, according to S&P.
The market has rebounded with a general resurgence in investor demand for high-yielding debt at time when cash is yielding virtually nothing. Because loans are floating-rate, they can also offer investors protection against rising interest rates.
One group of investors that haven't returned are collateralized loan obligations—debt instruments made up of pools of leveraged loans—that once put the market on steroids. CLO creation has remained all but dead since the onset of the crisis.
Mutual and pension funds have picked up some of the slack. Loan-focused mutual funds have enjoyed steady inflows since the end of 2008, including more than $8 billion this year, according to Lipper FMI, more than doubling their assets under management.
Yield-seeking investors are being compensated fairly well, with loans offering coupons of more than four percentage points over the London interbank offered rate. During the boom, that spread often fell well below three percentage points.
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