LBO financing main driver of issuance

Although it is far from being at pre-credit crisis levels, the market for new leveraged loans is healthy and once again driven by financing for leveraged buyouts.

"LBO financing is at the forefront of activity in the leveraged loan market," wrote Thomson Reuters in a Sept. 12 credit market report. Completed LBO loan volume for the third quarter already reached $11.7 billion as of mid-September. The LBO backlog, at $9.9 billion, is also significant, potentially making the third quarter of 2011 one of the biggest LBO quarters since the third quarter of 2008, according to Thomson Reuters.

Sure, the leveraged loan market is far from its heyday during the second quarter of 2007, when issuance of LBO loans reached nearly $60 billion. Additionally, investor skittishness due to an uncertain economic backdrop and concerns regarding the European sovereign debt crisis could present potential risks for arrangers pricing deals.

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But leveraged loans have shown stability, which has also translated recently into sound collateralized-loan obligation structures.

"As an asset class, U.S. senior secured leveraged loans have exhibited stable fundamental values through time due to the value of their collateral and seniority versus other creditors," said Jason Cameron, Senior Portfolio Manager of CDOs and CLOs at Cutwater Asset Management.

One of the reasons for the leveraged loan market's quick comeback is the attractive yield it offers relative to its risk. The average overall market yield for leveraged loans, which are at the top of a capital structure and are typically considered safer than bonds, was 8.21% as of the beginning of September, up from 5.5% at the end of March, and only a touch lower than high-yield bonds' yields at the same time, which stood at 8.4%. The average yield on single-A corporate bonds was 2.79%, lower than the historical median of 5.36%.

In a world where yields on many fixed income products are extremely low, leveraged loans have been attractive and their stability has also brought back an interest in CLOs.

"CLOs have proven to be relatively stable and resilient in part due to the underlying value of the loan assets backing them," said Cameron.

Another factor that has helped the CLO market since the 2008 credit and liquidity crisis is the fact that its buyer base has changed. While operating finance companies like structured investment vehicles and conduits represented the bulk of buyers prior to the crisis, they have since disappeared following heavy losses and have been replaced by more stable Asian banks and insurers.

Investors were driving riskier deals in the first part of the year when demand for leveraged loans was growing.

"Covenant-lite loans were an issue earlier in the year when we had inflows into high yield and there was so much demand that issuers were able to better negotiate terms," said Steven Huber, Portfolio Manager in the Fixed Income Division at T. Rowe Price. But structures have looked more conservative since the high volatility of the summer. "Lately, that pendulum has swung back and covenant-lite deals are less prevalent."

Huber noted that covenant-lite leveraged loans currently represent roughly 25% of all leveraged loan deals year to date.