Managing a loan portfolio these days may feel like a roller coaster ride with no seatbelt. In the past six weeks, the car has been inching up the incline, along with secondary loan prices and the number of repayments. However, market participants believe the loan market is about to take another plunge.

Nowhere else has the recent rally made more of an impact than in the CLO market. Since the start of June, the average spread for a triple-A-rated tranche of a U.S. CLO has fallen more than 200 bps to around 650 basis points, according to a recent Bank of America Merrill Lynch report. For double-A-rated and single-A-rated tranches, prices have risen past 45 and 23 cents on the dollar, respectively. In mid-May, the average price of double-A-rated tranche was around 23 cents, while the average price of a single-A-rated tranche was roughly 13 cents. As a result, many broadly syndicated vehicles have seen their overcollateralization cushions improve.

The rally has even impacted loans at the other end of the spectrum, with the price of triple-C-rated loans rising past 60 cents on the dollar in June, according to Standard & Poor’s Leveraged Commentary and Data. The price of those loans had drifted down into the 40s since December. Average overall secondary loan prices have increased too, with one market barometer, Markit’s LCDX index, rising to 86.32 on Wednesday from 79.79 on April 15.

Another positive sign: In the month of May, mutual funds that invest in leveraged loans experienced inflows topping $600 million. Moreover, last week, advancers on the secondary loan market outpaced decliners by a nine to one ratio.

The rally has put frowns on some distressed debt investors’ faces. The recent improvement, and how distressed investors should handle it, is reportedly going to be a hot topic at the IIR Conference on distressed debt next week in London.

The explosion on the high yield bond market in terms of new issuance is one contributing factor to the rally. More than half of the high yield bonds sold so far this year have gone to pay down bank debt, according to S&P. In 2007, only 17% of the bonds sold went to pay down bank loans. This has translated into loan investors recouping some, if not all, of their investments
Another factor has to do with lenders allowing companies to amend their loans. Lenders have been more willing to let companies amend their loans because they don’t want to force a company to default and have to deal with trying to recover their investment, if there is anything to recover.

With year-to-date returns on the Standard & Poor's/Loan Syndications and Trading Association index topping 30% last week, investors who were scared off at the onset of the crisis have returned to buy nearly $200 billion in CLOs since the rally began in late April, according to S&P LCD. Investors bought these securities because they returned better than other investments.

In addition to internal improvements — debt repayments and amendments — the loan market has also received some help externally.

“Despite the lack of direct government support for the product, the same actions that were undertaken by fiscal and monetary authorities to restore the flow of credit have indirectly spilled over to CLO market, at least from a market prices perspective,” analysts at Bank of America Merrill Lynch said in the report. “We believe the current rally in CLO prices is best explained by the combination of reduced risk premiums, which is a function of the increased risk appetite seen across other, more liquid asset classes, and the scarcity of supply, which we believe is an indirect consequence of authorities backstopping the financial system.”

Financial institutions, after all, were the biggest CLO investor, they added. The government backstop, the analysts said, has “removed disorderly asset sales from the equation.”
But while most market participants agree the rally has helped, they don’t see it lasting much longer. “There has, and will be, a recovery; but it will take a while for the loan market to return to normal,” said a New York-based banker. “Call me when you get an average loan price with a nine in front of it.”

Another New York-based banker added, “The secondary market has hit a plateau, and I don’t foresee [the rally] going much higher.”

CLOs are still facing pressure from downgrades to their underlying loans. Most CLOs have to frequently perform overcollateralization tests, which require them to maintain a certain mix of assets. If one bucket becomes too full, the CLO has to dump the paper at a loss. And the underlying assets in CLO portfolios have been getting slapped with downgrades lately.

At the end of April, the number of CLOs breaching their overcollateralization tests increased by a staggering 36%. Some market participants say more than half of all U.S. CLOs are failing these tests, so an increase in the number of downgrades could bring the rally crashing down.
To some, the recent rally has been driven primarily by all of the fundraising on the high yield market and elsewhere. This means that, while the cash is there, a true fix may not be. “We consider this rally as a mostly liquidity-driven event, one that may very well run further, but still not enough to make us alter our cautious stance on collateral risks and risk preferences at the CLO security level,” the Bank of America Merrill Lynch analysts said in the report.

Some market participants say it’s impossible to even truly call this a rally, considering that most loans were trading at, or above, par just over two years ago.

“The rally comes off of abnormally low levels that should never have been reached,” said a New York-based investor. “I would argue that the majority of the loan market is rather fairly valued today, and I don’t expect the same increases going forward.”

 

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