Cracking the Code (Part Three)

Investors are paying attention to loans as an asset class today for three reasons. First, default levels and price volatility coming out of the Great Recession returned to normal way faster than anyone anticipated. Second, the scare of defaults and volatility convinced portfolio managers that being at the top of the capital stack as a secured lender was a pretty good place to be. And finally, attractive yields – in the midst of so many unattractive alternatives – have made loans excellent places to park cash.
 
And oh, what cash. To say that there’s a lot of cash out there sounds like a quote from Captain Obvious, but it’s hard to overstate. Equities and money markets are spewing money like crazy, and it’s all going into high yield and loan accounts. Those dollars are then going to feed new issues, driving spreads down and prices up.
 
Look at what’s happening to relative yields. New junk bonds are flaunting 7.5% average coupons, compared to 10% in the pre-Lehman days. That equates to a spread of comparable Treasuries plus 630 bps (or T+590, pre-Lehman).
 
Leveraged loans, on the other hand, are currently being priced at L+551 bps (per the S&P/LSTA index). With Libor floors of 1.75%, that’s an all-in yield of 7.26%. Throw in 30 bps of fees (assuming 150 bps amortized over a 4-year deal life) and you’re at 7.56%, right on top of high yield.
 
Which would you rather own? (See first paragraph.)
 
Not that the love affair with bonds is ending anytime soon. There are too many funds that are fixed income hounds for a slowdown to happen. And the combination of a low interest rate environment and tepid economic growth are catnip to them. But from a relative value perspective, investors are beginning to take notice.
 
The real question is what will happen to yields between now and the end of the year? Directionally, “down” seems to be the consensus view. The only prop on spreads will be cross-over bond buyers into loan funds. They’ll demand comparable returns, and should get them, as long as loan arrangers have big enough order books to fill.
 
Which is why managers of BDCs and SBICs are considering first lien loans for their portfolios. They’re betting returns of those top tranches will hold up, so will diversify well with higher coupon (and higher risk) second lien, unitranche, and sub debt holdings.
 
Of particular interest to those investors should be middle market loans. Unlike their broadly syndicated counterparts, mid cap spreads and prices aren’t as impacted by fund flows in the institutional markets. They move with the appetites and capacities of middle market lenders. Right now, both are reasonably sized, but not overwhelmingly so.
 
Indeed, the smaller deal space may prove to be an oasis for the risk-averse this year. Leverage should remain “in the box,” which means less than 3.5x Ebitda for senior debt, and less than 5x for total. And all-in yields should stay in the 7% range.
 
Which considering the options, isn’t a bad place to be. Now, if investors could only get a scooch of leverage. Next week, we’ll wrap up our series by figuring out if they can.
 
Randy Schwimmer is senior managing director and head of capital markets at Churchill Financial, as well as columnist for its weekly “On the Left” newsletter. Reach him at rschwimmer@churchillnet.com.