I’ll be brief in introducing this story on leveraged loans in today’s Financial Times, but you might also want to view its companion piece, a story on Citigroup CEO Chuck Prince’s remarks on this market.
Leveraged loan prices are at their lowest point since the start of the Gulf War. Some see it as a vote of no confidence in the LBO market; others regard it as a healthy sign, that speculative excesses are coming to an end. Regardless of the cause, it’s a rude awakening for private equity players.
From the Financial Times:
The price of junk-rated loans in the US and European markets has tumbled in the past couple of weeks as investors begin to turn away from the asset class, according to new data from S&P LCD, the market information service.
US leveraged loan prices have fallen to their lowest level in more than four years, while in the derivatives markets a sell-off has pushed the prices of both US and European loan risk to less than the face value of the loans themselves.
The fall in prices is significant for banks and private equity firms preparing to launch new debt deals after recent buy-outs because it implies a rise in loan yields, which means higher borrowing costs.
Leveraged loans, which are used to fund most of the value of private equity backed buy-out deals, have enjoyed a boom as the markets have opened up to new kinds of investors attracted in by high yields and stable historical performance.
Growing concerns about the level of borrowings employed by private equity and the aggressiveness of debt structures, coupled with the problems in the US subprime mortgage market, have sparked a crisis of confidence in debt markets.
The average price bid for outstanding loans in the US has dropped to almost 50 cents below the $100 face value used in the market from a peak in February of about $101.
S&P LCD said this was the lowest level seen in the US since May 2003 – soon after the invasion of Iraq and near the trough of the last broad bear market.
In Europe, the hot competition to buy loans, which has been driven by the flood of new managers of the complex investment vehicles known as collateralised loan obligations, has meant the average bid had been above €101 all year.
But the price has fallen 34 cents over the past two weeks, which leaves the average bid at about €100.69, the lowest level in more than a year at least.
Some established investors who have long complained about the rising cost of loans in Europe see the correction as good news, allowing them to pick up some bargains, and say it is a sign of the hot money getting out.
“There has been a massive over-allocation to the loan markets as the demand was so high that plenty of people thought they could buy the debt at face value when it was issued, and then flip into the secondary market for an instant profit,” says one London-based investor.
Hedge funds in particular appear to be starting to withdraw from the market, the investor added.
Another factor weighing on loan trading is the level of prices in the very young market for loan derivatives. In the US and in Europe indicative loan prices have been trading some way below face value.
The introduction of indices of loan derivatives has been important in allowing a broader range of players to short sell loan risk, which has helped to drive prices into negative territory.