Credit markets are riding waves of money
Investors seeking yield on business loans can be overwhelmed by loads of cash, sometimes even from Special Purpose Acquisition Companies, or SPACs, and mainstream banks.
The prospect of inflation and rising rates makes variable rate debt like business loans increasingly attractive to a wide range of investors. But for now, there isn’t too much return offered: the return to maturity of the S & P / LSTA Leveraged Loan Index this year has fallen from around 4.7% to less than 4, 4%, hitting its lowest level since April 2004, according to S&P LCD Screen of Global Market Intelligence. The index spread over the Libor benchmark is also close to its lowest level since mid-2019. Dividend yields through business development company lenders are also declining. Meanwhile, yields on US Treasuries rose from around 0.9% to over 1.6%.
A surge in investor demand in the loan markets is occurring at the same time as paper in the market is becoming scarcer. Although activity in the loan market has been high this year, much of it has been refinancing or revaluing existing debt, according to LCD. So, on the net, the size of the syndicated loan market tracked by the S & P / LSTA index has actually declined since last April, according to LCD.
An interesting factor that sometimes contributes to scarcity is the money collected by PSPCs and used to finance leveraged business acquisitions. The trend is visible in the private debt market in BDC portfolios.
recently told analysts that a banker called it a “SPAC factory” because many companies on its global platform – nearly two dozen – are somewhere in the process of being acquired by these vehicles.
Raising funds through a PSPC arrangement can make borrowers more creditworthy, which benefits BDCs. But if the debt is ultimately paid off or refinanced in another market, then lenders and loan funds must find new debt to invest in at a time of intense competition. LCD, in a recent memo, called the influence of PSPCs both “roses and thorns” for private debt buyers.
In the broader loan market, a few borrowers have announced PSPC deals where the proceeds are used in part to repay debt, such as the parent company of casino and restaurant company Golden Nugget / Landry’s, or have subsequently revalued the debt. Also, unlike a private equity acquirer, PSPCs typically do not issue new debt when purchasing a business. Meanwhile, new loan issuance to fund mergers and acquisitions or buyouts declined 10% year-over-year in January and February, according to LCD.
A more important factor in helping borrowers reduce the costs of debt is a huge buying force in the market: Secured Loan Bonds, or CLOs, which themselves benefit from cheaper financing. So, they can still earn a decent spread even if the loans pay less. This time, a year ago, there were concerns that a wave of defaults could shatter the CLOs, but it did not materialize. Instead, CLOs appear to be benefiting from another wave of liquidity, the surge in bank deposits.
At a time when bank customers like large corporations and consumers are still not borrowing much, banks are looking for other places to put cash, especially in investments that can benefit from rising rates. This makes senior CLO debt an attractive option, resulting in a “noticeable increase in bank demand” for this type of paper, according to analysts at Morgan Stanley.
A result of all this investor demand is that riskier borrowers – those rated B-minus or lower – accounted for a historically high percentage of leveraged loan issuance until mid-February, over 40%, according to LCD. This is a good sign for the economy, helping companies keep financing on the cheap even as Treasuries signal a rate hike. But it also means investors can be exposed if and when short-term rates rise and a struggling company can’t refinance at such a low cost.
Many doom predictions for leveraged companies have not come to fruition, and so may be this time around. But investors need to understand the dynamics of what they’re buying into.
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Appeared in the print edition of March 19, 2021 under the title “Credit Markets Surf on Waves of Money”.