Shooting Over Par

Fed officials who don’t see signs of inflation haven’t been watching loan prices.

As credit markets healed over the last two years, investors saw loans behave in a recovery as they were designed to. Default rates fell and recovery rates rose, proving the asset class could withstand a hundred year flood and come out barely moist.

Three months after Lehman failed loan prices in the secondary market reached a record low of 65 cents on the dollar. At the time, no one knew whether a bottom had been reached. Anxiety reigned and markets had no clear guidance on a path to recovery.

But savvy investors, recognizing this deep discount contained more fear than fundamentals, began buying. As markets stabilized, this buying became widespread and prices rose, wringing worry out of the equation. Repayments from the high-yield issuance boom further fueled the trend, as cash-rich buyers went bargain hunting.

Today the S&P LCD index of most liquid loan names stands at 96.18, a three-year high. The bargain hunting is over. Indeed, it has become a bid-only market, i.e. no sellers. Who wants to give up a good earning asset when there are so few to replace them?

Which brings us to new issues. This was a par market for years, meaning institutional loans were issued at no discount, 100 cents on the dollar. Investors received a Libor spread, period. After the Crunch, to entice buyers into the market arrangers had to offer new loans at significant discounts to par. Beginning at 91 in April 2008, these “original issue discounts,” or OIDs, have risen steadily to today’s level of 99.

The real news is what’s happening to prices after deals open for trading. A skilled arranger allocates accounts just short of their commitments and prices the deal slightly “cheap to the market.” This potent mix sets the stage for a liquid secondary market allowing the loan to trade “on the break” one percent or so higher than the OID.

But as we said last week, arrangers are allocating shares in an increasingly lop-sided fashion: the “haves” are loaded with inventory for their own books, while the “have-nots” are scrambling to get any decent positions at all. The result has been a feeding frenzy.

A good example is Getty Images, the Hellman & Friedman recap, which opened last Thursday at 101, after being issued at 99, and immediately jumped to 101.5.

So a loan structured to entice Buyer A by promising they will be repaid $10 million on their $9.9 million principal investment (not including interest) is sold to Buyer B in the secondary market. And Buyer B pays $10.15 million for the right to only get their $10 million back. In the immortal words of Yakov Smirnoff, What a country!

Of course, Buyer B is betting their investment will continue to trade up, allowing them to sell to Buyer C, and so on. That’s probably a good bet, given the wacky supply/demand imbalance which is sure to continue to push large cap spreads down and prices up.

But as with consumer price inflation, rising loan prices not only devalue assets, but can take some buyers (like CLOs, who have limited capacity to buy loans at a premium), out of the market. And losing investors is not something the loan market can afford.

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