As Rates Tick Up, LBO Bankers Watch Warily

Ben Bernanke, the chairman of the Federal Reserve Board, set off ripples across the credit industry when he said in May 22 testimony to Congress that the Fed might “taper” its purchases of bonds through a program called quantitative easing that has pressed interest rates to record low levels.

The impact seems not to have reached the mid-market leveraged finance space, however. “We have not seen any changes in interest rates yet,” said one banker who is currently shopping five mid-market financing deals. “There is still not a lot of demand for capital.”

Leveraged finance is somewhat cushioned from trends in broader credit markets, because spreads there—generally expressed as basis points above a benchmark rate such as Libor—offer protection to investors in the asset class.

Conditions also vary between the broadly syndicated loan market, where investors can trade in and out of specific credits, making the segment more subject to fluctuations in the broader market, and the middle market, where creditors more often have to live with the deals they make for years to come. As a result, one lender told Buyouts: “Middle market loans, especially lower middle market loans, are less liquid. You are insulated a little bit from all the external pressures out there.”

Yet even there, pressure is beginning to show. For instance, prices for existing syndicated loans are falling. Sister service Thomson Reuters Loan Pricing Corp reported in early June, for instance, that the SMi100, an index of syndicated loans, slipped from just above 99 on May 27 to 98.78 by May 31, before inching down a bit further to 98.72 on June 5. This downdraft represents the greatest drop in the secondary loan market since the end of January. And because prices move inversely to yields, lower prices on such loans means higher returns to investors who purchase those credits, an indication that the market is anticipating higher rates on new-money loans in the future.

U.S. leveraged loans had a relatively modest correction but remain well insulated as the only major fund class to see inflows during the first week of June, LPC reported. Nearly $1 billion of cash flowed into bank loan mutual funds, compared to a record $4.6 billion outflow from high yield, according to Lipper FMI. The outflow from high yield is seen as an indicator of investors seeking safer places to put their money.

In another indication of tighter credit conditions, asset manager TCW Group withdrew the repricing of its $354 million term loan B due February 2020 citing current market conditions, sources told LPC. The repricing deal attempted to lower the spread to LIB+200-225, with a 75bp Libor floor. The company entered the existing originally $355 million TLB last December to finance its LBO by backing The Carlyle Group. The loan finalized at LIB+300, with a 1 percent Libor floor. That loan reverse flexed during syndication, bringing its spread down.

Broader credit markets have responded more strongly to Bernanke and signs of economic strength. The benchmark 30-year fixed-rate mortgage crossed the 4 percent level in early June, rising to 4.1 percent, compared with 3.99 percent the week before, according to a Bankrate.com survey of large lenders. The last time the 30-year fixed was this high was April 18, 2012, when it also averaged 4.1 percent in Bankrate’s survey.

The yield on the 10-year Treasury note, which moves inversely to price, rose 3 basis points, or 0.03 of a percentage point, to 2.11 percent, on June 7, as MarketWatch reported, after nonfarm payrolls grew by 175,000 jobs, more than expected. The bellwether Treasury had been below a 2 percent yield since early 2012 before beginning to move higher earlier this year.

Shorter maturities show the same trend, although investors’ appetite for yield is keeping yields for speculative grade issues relatively low, even as yields are climbing more rapidly for safer instruments.

During May, the yield on the five-year Treasuries rose 40 bps to 1.05 percent, while the yield on speculative-grade nonfinancial bonds rated ‘BB+’ widened by 67 bps, and the yield on those rated ‘BB/BB-’ and ‘B-’ rose 41 bps and 46 bps, respectively, Standard & Poor’s Financial Services LLC reported. “However, the increase in Treasury yields is more substantial in a relative sense, and it has resulted in a decrease in the spreads on five-year speculative-grade bonds,” said Diane Vazza, head of Standard & Poor’s global fixed income research, in a report. “As a result, speculative-grade industrial debt has remained all the more attractive to investors, despite speculation about when this run in profitability will end.”

So far, though, the uptick in rates has not dampened demand by companies to issue high-yield credit, as Moody’s Investor Service reported on June 3. “Demand continues to be exceptional year-to-date for both high-yield bonds and leveraged loans despite the modest uptick in rates,” the credit rating agency said.

Still tightening credit could mean trouble in the future for leveraged borrowers. Moody’s, which tends to focus on companies’ long-term ability to repay their debt, also warned in June of a “covenant bubble” driven by strong investor demand for higher-yielding instruments at a time of low interest rates. As the agency said: “The Fed’s eventual shift to tighter monetary policies and higher interest rates could shift market dynamics abruptly. A lack of liquidity in the leveraged finance market would lead to more distress among low-rated companies, sending investors back to their credit agreements to analyze their covenant protections.”