Loan Gains Smallest Since 2008 as Fed Sees Froth: Credit Markets

Leveraged loans are delivering the smallest returns at the start of a year since 2008 as the Federal Reserve and other regulators warn that the $561 billion market may have become too frothy.

Speculative-grade loans have gained 2.1 percent in 2013, compared with an average of 5.6 percent in the same period the last four years, according to the Standard & Poor’s/LSTA U.S. Leveraged Loan 100 Index. JPMorgan Chase & Co. is forecasting the debt will return from 5 percent to 6 percent in 2013, or about half the gains seen last year.

The slowdown may signal that investors are heeding the concern expressed by the Fed that money for the neediest borrowers is too easy even though default rates are below the historical average. Investors pushed back on terms of some deals, demanding that Blackstone Group LP-owned Apria Healthcare Group Inc. pay more for a $900 million loan it’s seeking.

“An investor shouldn’t expect to earn what they earned last year because we started with a different set of initial conditions,” Beth MacLean, a money manager at Newport Beach, California-based Pacific Investment Management Co., said in a telephone interview. “This year you don’t have the capital appreciation upside and it’s really more of a coupon clipping year.”

Loan Rates

The interest rate paid on loans bought by non-bank lenders was 3.95 percentage points more than lending benchmarks on March 21, rising from a more than four year low of 3.78 percentage points in February and headed for the first monthly increase since November, according to S&P’s Capital IQ Leveraged Commentary & Data. The so-called margin has narrowed from last year’s high of 5.15 percentage points in June.

The price of leveraged loans has risen to the highest level in almost six years, increasing more than 2 cents from year-end to 98.31 cents on the dollar yesterday, according to the S&P/LSTA U.S. Leveraged Loan 100 index. Loans climbed more than 5 cents on the dollar in 2012, finishing the year at 96.09 cents, the biggest annual jump since 2009.

As investor demand rises, companies are issuing the debt with fewer safeguards at a record pace. About $82 billion of so-called covenant-light loans have been raised this year, approaching the $87 billion during all of last year and the peak of $97 billion in 2007, according to S&P Capital IQ LCD.

Regulatory Concern

Prudent underwriting practices have deteriorated with the inclusion of covenant-light transactions and less-than satisfactory risk management practices, according to guidance on March 21 from the Fed, the Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency.

Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. fell. The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, declined 1.41 basis points to 91.09 basis points, according to prices compiled by Bloomberg.

The indexes typically falls as investor confidence improves and rises as it deteriorates and fall as it improves. The contracts pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Commercial Paper

The market for corporate borrowing via short-term IOUs expanded for the first time in four weeks, led by a rise in issuance from non-U.S. financial institutions.

The seasonally adjusted amount of U.S. commercial paper climbed $5.3 billion to $1.022 trillion outstanding in the week ended yesterday, the Federal Reserve said today on its website.

Bonds of Rotterdam-based LyondellBasell Industries NV were the most actively traded dollar-denominated corporate securities by dealers today, accounting for 5.38 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Moody’s Investors Service estimates the U.S. speculative-grade default rate will “remain low,” ending 2013 at 2.5 percent, down from 3.3 percent in February. The default rate went from 1.06 percent at the end of 2007 to a peak of 14.7 percent in October and November 2009, according to the ratings firm.

“Since defaults are so low, even if spreads have tightened, the excess spread that you get over your default expectations is higher than it was pre-crisis,” Pimco’s MacLean said. “On a relative value basis, there are very few places where investors can get a decent current coupon.”

Loan Issuance

Borrowers obtained $182.7 billion in loans this year from non-bank lenders, more than half of what was issued in all of 2012, according to JPMorgan. About 47 percent of these loans were used to reduce borrowing costs.

Financings include a $500 million covenant-light loan backing Apollo Global Management LLC and C. Dean Metropoulos & Co.’s purchase of Hostess Brands Inc.’s snack-cake business and a $1.16 billion debt for drugstore chain Rite-Aid Corp., Bloomberg data show.

“The balance is clearly tipped into the favor of the issuers today,” MacLean said, adding that Pimco, the manager of the world’s largest bond fund, has participated in less than half of newly issued and refinanced loans this year. “We are letting some of the re-pricings go that don’t make sense, and some of the new issues that are more aggressive we’ll pass on,” she said.

Blackstone’s Apria

Blackstone’s Apria Healthcare, based in Lake Forest, California, raised the rate on its loan by 1 percentage point from its original proposal to attract investors earlier this month.

The provider of home healthcare products and services in the U.S. is now offering 5.5 percentage points more than the London interbank offered rate, up from 4.5 percentage points initially proposed, according to a person with knowledge of the matter who asked not to be identified because the terms are private.

Officials at the Fed, whose asset purchase program and low interest rate policy was put into place to rescue the U.S. economy and get credit flowing again, are now expressing concern that debt yields near record lows aren’t compensating investors for their risk.

It’s “unrealistic” to expect loan returns this year will be as strong as last because the rise in loan prices that drove 2012 gains won’t be matched, Scott Baskind, a New York-based senior money manager for Invesco Ltd.’s bank loan group, said in a telephone interview. The coupon will be the largest component to returns in 2013, he said.

Loan Yields

Investors poured $1.4 billion into U.S. funds last week that buy leveraged loans, the second-biggest inflow after the record $1.5 billion during the second week of February, according to Bank of America Corp.

Leveraged loan yields fell to a record 5.6 percent yesterday, according to JPMorgan index data. The yield-to-worst, or the lowest potential yield received without a default, on U.S. junk bonds was 5.63 percent yesterday, compared with the record-low of 5.6 percent on Jan. 25, according to Bank of America Merrill Lynch indexes.

“If it’s a nine-inning baseball game and a sustained move higher in the default rate represents the ninth inning, then we’re probably in the fourth/fifth inning,” JPMorgan analysts led by Peter Acciavatti wrote in March 22 research report. “While the peak in credit quality is behind us, it doesn’t mean conditions have rapidly declined.”

Investors in loans have more downside protection than bonds as they are paid first in bankruptcy or liquidation, while offering a hedge against inflation because the coupon on the debt is tied to a floating-rate benchmark.

“The loan market is a place to capture, and protect against, a rising rate environment,” said Invesco’s Baskind. Loans offer “very similar, comparable yields” to junk bonds with less credit risk.

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