As the International Swaps and Derivatives Association prepares to release standards for trading leveraged loan credit default swaps - the market is expected to skyrocket just as the CDS of ABS market has thrived under increased standardization and liquidity. Syndicated loan volume alone has boomed over the past several years - reaching more than $3 trillion globally and constituting more than a third of all syndicated lending within the U.S., according to Fitch Ratings.
Already, several U.S. dealers are making markets in at least 80 to 100 names, according to James Batterman, a senior director at Fitch. Collateralized loan obligations are expected to benefit from the rise in LCDS activity, similar to the increase in flexibility felt by ABS CDO managers. CLO managers will be able to reference a wider range of assets, both in terms of vintage and name - assuming the synthetic market will include more obscure names. They should also be able to ramp up deals within a faster time period. "In the same way that investment-grade credit default swaps triggered a huge growth in the investment-grade CDO market, many market participants are expecting that leverage loan CDS will do the same for the CLO market," said Jeremy Carter, a director at Fitch, during a conference call on the matter late last week.
Due to increasingly tight spreads throughout the loan market, CLO managers have had a difficult time sourcing collateral. CLO managers last year found themselves dipping into the same pot of securities in order to ramp up their deals at a higher rate than in recent years, according to an analysis by JPMorgan Securities released last month (see ASR, 05/01/06). The issuance of CLO deals has outpaced the availability of new collateral to back them, fueling increasing overlap between U.S. CLOs in recent years as the market has ballooned. Some 29% of securities in 2005 were referenced in more than one CLO deal, compared with 22% for the 2002 vintage CLO, 27% for 2003 and 23% in 2004, the investment bank found through a sample analysis.
But while the emerging LCDS market will provide managers with an opportunity for a more diverse range of collateral, the search for yield may not stop at LCDS. The sector, on average, is expected to trade at about half the spread offered on the so-called vanilla credit default swap market, according to Batterman. This is because of the traditionally high recovery and performance rates experienced in the market. All else equal, the higher the expected recovery, the lower the premium of protection should be, he noted.
Structurally, LCDS should be very similar to vanilla CDS. The obvious difference is that the reference entity will be a loan instead of a bond - making the reference obligation typically secured. Most of the trades will have a principal tenor of five years, and credit events should mirror those in the broader CDS market. Restructuring, however, may not be an option in the U.S. market, according to Fitch.
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