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Amid shutdown, investors ponder what it will take to open leveraged loan market

With the $1.2 trillion U.S. leveraged loan new-issue market largely in lockdown and the prospects for a near-term return of widespread activity uncertain, to say the least, investors and originators remain on the sidelines, waiting for the segment to reopen.

But what will it take for that to happen?

Of course, this depends largely on how well countries manage the coronavirus pandemic, and the resulting economic shutdowns.

But one technical dynamic is clear enough at present: For new-issue activity to return to the U.S. loan market, loans must bridge what is now a wide-yield gap between what it would cost investors to take on a new deal today, versus the relative bargains on offer in the trading market.

Determining the actual cost of capital in today's new-issue market is difficult, as only a handful of U.S. leveraged loans have emerged since the coronavirus shut down countries around the globe (a scant $1.8 billion in new institutional loans have been issued in April, through April 22, after no issuance in March). Nearly all were from companies hit particularly hard by COVID-19, as they scramble to shore up liquidity.

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High-profile among those deals are Revlon, Everi Payments, Landry's, AGS and Surgery Center, which total $1.5 billion. Each offered double-digit yields, in the low- to mid-teens, reflecting just how deep issuers have needed to dig to entice investors away from opportunities in the secondary market. Late this week, Delta Air Lines Inc. emerged with a $1.5 billion, three-year term loan as part of its efforts to bolster liquidity, setting price talk at L+500, with a 1% LIBOR floor and an original-issue discount of 97.

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In today's trading market, the current discounted spread to maturity of a first-lien loan issued to a double-B rated borrower is L+315, according to the S&P/LSTA Leveraged Loan Index. Moving down the credit spectrum, the current discounted spread to maturity for a single-B issuer is L+639. These numbers are up markedly from pre-pandemic levels.

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By comparison, in the primary, while there is not enough issuance today to determine a meaningful reading, the reading from January, before the pandemic took hold, shows a spread of L+215 for double-Bs and L+350 for single-Bs.

Obviously, any new-issue transaction undertaken today needs to offer a spread attractive enough to lure investors from the secondary market.

All eyes on CLOs
This brings us to CLOs, of course, the most important investor segment in market.

CLOs are able to buy many loans below 90 in the secondary, leaving a fairly wide swath of the $1.2 trillion in U.S. leveraged loans outstanding available to this investor segment. As of April 15, roughly 20% of Index loans were priced from 80–90. Another 27% were priced from 90–95, and 30% from 95–98.

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CLOs continue to grapple with a flood of loan rating downgrades, which are embedded in CLO investor protections. If CLO portfolios become too distressed, these vehicles will be unable to buy new paper, and will cease to provide liquidity to the loan market.

Finally, exacerbating the demand picture, retail investor outflows from the loan asset class since early March are north of $10 billion, according to Lipper.

Beyond technicals, for the primary market to return there needs to be a strong rationale for leveraged loan issuance in the first place. LBO activity will certainly slow until at least the second half, sources say, as potential target companies need to be revalued. Likewise, private equity firms looking for a return on equity will be cautious to take on debt that would consume excessive portions of portfolio companies' free cash flows.

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And the lack of a significant maturity wall for loans in 2020 leaves limited incentive to issue refinanced debt.

Crises past
A look back to past periods of volatility may serve as a guide to what lies ahead for today's loan market. For M&A deals rated single-B, average spreads in the fourth quarter of 2007 were L+321 (the pre-crisis peak in the Dow was October of that year). This figure shot to L+539 by the second quarter of 2010. All-in yields fell by roughly 2% in that time, however, on the back of declines in LIBOR.

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More recent was the risk-off rout in the fourth quarter of 2018. New-issue spreads jumped from L+403 in third quarter 2018 to L+441 in first quarter 2019, and all-in yields increased from 6.68% to 7.66%.

Sources add that issuance would most likely need to come from the higher-rated end of the spectrum. A double-B rated deal in a defensive industry could reopen the market for new borrowers, but they would need to pay up, with the option of a repricing in six months should conditions improve. Consider that LBO and M&A deals such as LifePoint Hospitals, Dealer Tire, and Dun & Bradstreet that were issued during the unsettled period spanning fourth quarter 2018 and first quarter 2019 were part of the massive repricing wave earlier this year, after their soft call protections had rolled off.

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