Companies still have upper hand in U.S. leveraged loans

• Demand allows lower-rated issuers slash yields

• Call protection period cut to six months

• Companies increasing loan sizes, shortening commitment dates

Investors battling for floating-rate assets to hedge rising interest rates, often favoring secured loans over riskier junk bonds, are empowering lower-rated companies to keep slashing yields and whittling away buyer protections.

One twist loan investors are increasingly grappling with is a six-month call protection period that is half the prior norm. Many companies have the incentive, now in much quicker order, to swipe higher-yielding loans away from investors and issue new lower-cost loans.

Of the 88 first-lien institutional loans that have been reported by Thomson Reuters LPC so far this year, companies cut yield spreads on 31 deals and increased them on just two.

Companies this year also increased loan sizes, pulled forward commitment dates and have seen prices rise in secondary trading based on seemingly unrelenting investor appetite.

“We do still prefer loans over bonds broadly because they offer better safety,” said Anthony Ranaldi, executive vice president and portfolio manager of DDJ Capital Management in Waltham, Massachusetts.

“We’re clearly at a tight point in the credit cycle … in this market we put a lot more value in safety than yield,” he added. Loans fit the bill because of their senior secured status and floating-rate characteristics.


Diluted Call Protection

So-called soft call protection for six months, a feature investors have accepted begrudgingly, is now typical. If a company returns to the market just to reprice at a lower coupon within the six-month window, it has to repay investors at a 101 premium for that option.

That premium buffers the pain of higher-yielding assets being called away so quickly. However, in 2012, up to 90 percent of new loans offered call protection of at least 101 for a full year, Barclays noted. A full year of this protection is now a rarity.

“While soft call protection is good, the strength of it has been diluted over the last three to six months,” said Joseph Lynch, co-portfolio manager of the Neuberger Berman Floating-Rate Income Fund in Chicago.

The U.S. leveraged loan market “is not investor-friendly and I wouldn’t expect that to change any time soon.”

In at least one recent case, the issuer of an acquisition loan – VAT Vacuum Valves AG – started with soft call protection at 101 for a year before cutting that to six months during the syndication process. Nonetheless, the company still was able to cut yield spreads and tighten the original issue discount price.

Last year’s torrent of repricings slashed the average coupon rate by 93basis points and nominal spreads by about 40bp, according to Barclays.

Yet investors keep boosting allocations to loans, Lynch noted, based on their relative appeal versus fixed-income markets. A broadly held view is “why not take less credit risk, and eliminate any type of rate risk for essentially the same total return.”

The total return outlook is 3-5 percent for loans and 4-6 percent for high-yield bonds this year, several fund managers and analysts estimate.

Retail money keeps pouring into loan mutual funds.

Inflows, racking up 84 straight weeks, reached nearly $3 billion in just the first three weeks of this year, Lipper said. That’s almost triple the inflows for high-yield funds, which had net outflows last year.


Rightfully Concerned

Protections do remain, even if watered down, another reason investors stay in loans.

With 80 percent of loans in the Barclays High Yield Loan Index at or above par, investors are “rightfully concerned” about a lack of upside as well as the risks of loan prepayment, Barclays wrote in a report.

The index topped 99 early this year for the first time since 2007, and remains above. Still, back then only about 20 percent of new loans issued had prepayment fees at all, said Barclays.

For issuers, part of the trade-off for their exposure to rising rates on floating-rate loans has been their ability to prepay for better terms if rates drop, said Tim Broadbent, head of Americas leveraged loan syndicate at Barclays. Faced with investor resistance, or demands for deeper discounts in exchange for the shorter call protection period, many companies have the flexibility to issue bonds instead.

“No shift is likely any time soon as issuers like the shorter call period and the robust market conditions continue to be very issuer friendly,” Broadbent said.

In another widely followed issuer-friendly development, some 40 percent of last year’s $625 billion leveraged institutional loans were covenant-lite, a record in both volume and percentage terms, Thomson Reuters LPC data show.

Safety and performance are overriding these concerns, most loan market participants agree.

In a January Bank of America Merrill Lynch survey, high-yield investors see leveraged loans as the sector’s top performers this year.

While covenant-lite deals hit a peak, and leverage last year reached pre-crisis highs, the default rate in the U.S. was the lowest since 2007-2008, BAML said in a high-yield strategy report.

“Certainly the power has shifted to the issuers of debt … and that’s not going to change for a while,” said Michael Contopoulos, BAML’s head of high-yield and relative value strategy.

Lynn Adler is a senior reporter for Thomson Reuters LPC in New York