Five Questions With… Lawrence E. Golub, President, Golub Capital

Spreads in the senior lending market are down about 200 basis points from six or seven months ago. What’s the most significant change that allowed that to happen?

The reopening of the high-yield market has caused a shark feed of zombie CLOs using their free cash to buy whatever senior secured loans rated B3 or better that they can find on the secondary market. These CLOs are zombies because their re-investment periods end soon and then they will be gone forever. But in the meantime, when a loan they own gets paid off with proceeds from a junk bond issuance, they stagger to market and put those dollars back to work in senior secured debt rated B or better no matter what the price. So the zombies have bid loan prices up to par and above. That reduces the yield in the broadly syndicated loan secondary market, and the new demand trigger repricings of healthy credits and even compresses prices in senior debt of smaller companies, but to a lesser extent. Stabilizing profits at the borrowers sure helps, too.

Bottom line: LIBOR today is practically zero! Golub Capital thinks that there is a good chance that all interest rates spike higher much faster than the futures markets are predicting. Not for sure, but a high enough chance so that borrowers need to have contingency plans in place for a 250 basis point or greater increase in LIBOR in the next 12 months and a return to historic levels of about 5 percent LIBOR within a year or two, in case it happens. The futures markets predict that LIBOR will be only about 1.60 percent in a year and only 3.7 percent in two years. But what if inflation picks up or issuances of U.S. Treasury securities accelerate and/or exacerbate that increase.

If debt becomes more expensive while company performance is still lackluster, will this lead to a new wave of shakeout among sponsor-backed companies?

Yikes, how many companies will bust a covenant if their coverage ratios get cut in half? Every decently performing company today has a great EBITDA-to-interest coverage ratio, with LIBOR at about zero. The math gets hard fast if LIBOR goes to 5 percent and, in effect, every company’s interest rate cost doubles. It will be ugly.

What can borrowers do to avoid or mitigate these impending price hikes?

The good news is that borrowers with decent loans in place can execute swaps and caps based off the forward curve, which is much more optimistic than our “bad case” predictions. So buying protection is cheap. We are urging our clients to think about their absolute interest rates, not just the spreads to LIBOR. Many companies should be refinancing now, so that they can lock in three to five years of rate protection before LIBOR goes up.

Compared to the peak period, what level of activity do you expect to see in 2010 in terms of new issuance?

In 2009, loan activity in the traditional middle market was down about 90 percent from the peak. We expect a healthy uptick this year, with volume in our market increasing to about 25 percent of the peak. Much of this will be from refinancings as opposed to new deals. Owners of some of the best performing companies will want to sell by Dec. 31 to take avoid higher capital gains taxes. Those companies that have not recovered enough to sell probably need to refinance in the next two years.

Edited for clarity.