Loan Market Isn't on Borrowed Time

Remember the halcyon days of June 2007? Stocks were soaring and the phrase "Greek ruins" inspired travel plans rather than bank runs. It was also the month that Canadian telecom giant BCE accepted an offer for what would have been the world's largest leveraged buyout, and the trailing default rate on leveraged loans fell to an all-time low of 0.15%.



A year later, stocks were past their peak and Greece was heading for disaster. Meanwhile, the BCE deal was dead and that default rate was on its way back up toward the 10.8% peak it hit in November 2009.

Today, the default rate is within a whisker of its all-time low, hitting 0.17% in November, according to the LCD team at Standard & Poor's Capital IQ. But the market clearly isn't buying it: Leveraged loans' average spread above Libor is 6.3%, implying a default rate running at 6.6%, according to LCD's Steve Miller.

The nexus of fear is in Europe—still long on speeches but short on definitive solutions to the euro zone's crisis. A banking panic there, freezing credit, would slam leveraged loans and other risky assets. Such fear is undoubtedly holding back buyout activity in Europe, down about 19% annualized according to Dealogic. Even if clobbered stock-market valuations are tempting, only the bravest private-equity firm would jump in today.

Yet investors with faith in Europe's ability to heal itself— such as those currently pushing down Italian bond yields—can also point to underlying strengths in the leveraged loan market. U.S. corporate profits have been growing strongly, bolstering balance sheets. The ratio of liquid financial assets to total liabilities for non-banks is now at its highest level since the mid-1970s, according to Citigroup.

Firms have also been knocking down the wall of refinancing built during the pre-crisis borrowing binge. At the end of 2009, $404 billion of leveraged loans were set to come due between 2012 and 2014, according to LCD. Now, the burden is under $150 billion as firms have paid off debt and refinanced with bonds.

The bigger issue will be finding buyers for new loans. The financial crisis left lasting scars on credit markets, including the sharp shrinkage of collateralized loan obligations. CLO funds were the go-to buyers of the go-go years. Barclays Capital estimates remaining CLO funds could absorb $60 billion of new loans next year, dwindling to perhaps just $10 billion in 2014. Issuance this year is forecast to be up to $175 billion. Despite the market's underlying strengths, therefore, leveraged loans will have to be priced to tempt non-CLO buyers, such as loan mutual funds.

Although the default rate will surely move higher over time, in the absence of a European meltdown a spike looks unlikely. On that basis, yields look attractive already.

Source: http://online.wsj.com/article/SB10001424052970204083204577082251565060684.html?mod=WSJ_Heard_LEFTTopNews