Technical conditions in the loan market worsened in July as net new supply outpaced visible capital formation – CLO issuance less outflows from loan mutual funds – by $5.7 billion.
Participants say the situation was exacerbated late in the month when high-yield mutual funds, hit by significant withdrawals, sold liquid loans to help meet redemptions. All told, Lipper FMI reported $5.4 billion of high-yield outflows in July, the worst reading since June 2013. And that was a mere prelude to the record $7.1 billion that mom-and-pop investors withdrew from high-yield funds during the first week of August.
Looking at the internal loan technical numbers, an increase in supply was largely responsible for weaker tone in July. During the month, the universe of S&P/LSTA Index loans expanded by $17.4 billion, to a record $774 billion, as several jumbo loans funded into the Index, including Gates Global ($2.5 billion), Ortho-Clinical Diagnostics ($2.2 billion), and LA Fitness ($1 billion), not to mention EFH’s DIP ($5.4 billion). In June, by comparison, net new supply totaled a more modest $9.4 billion.
On the other side of the supply/demand ledger, CLO issuance continued apace. Managers inked $13.4 billion of new vehicles, the second-highest monthly total on record, behind only June’s $13.8 billion. July’s activity lifted CLO volume during the first seven months of the year to $74 billion, versus $46 billion during the same period in 2013. CLO issuance in 2014 remains on pace to top 2006’s annual record of $97 billion.
Managers say several factors have pushed CLO volume to new heights while keeping the market in overdrive. First, the roster of AAA buyers has expanded enough to take down mass quantities of new senior liabilities in a L+144-150 context. Even so, managers report that the small club of lead buyers in the AAA segment are maintaining pricing discipline, so spreads are not compressing further. At the same time, cheaper collateral has created enough arbitrage to keep equity dollars flowing, managers report. Here’s a back-of-the-envelope calculation:
Assume, based on the data below, that managers can construct a portfolio today at an average yield that is 25 bps wider than what was on offer a month ago. Apply 10 turns of leverage typical of CLOs, and model-driven equity returns, and distributions, are wider by 2.5 percentage points, in perhaps the low double digits, from 8-10% during the second quarter.
While structured finance is hitting on all cylinders, retail remains stuck in reverse. During the first four full reporting weeks of July, loan funds that report weekly to Lipper FMI suffered $1.2 billion of redemptions, versus $2.5 billion during the same period in June. Those figures suggest that when all funds are counted – including those that don’t provide data to Lipper – loan-fund AUM will be down $1.7 billion in July, versus $2.6 billion in June. During the first week of August, amid falling prices in the equity markets and unrest across the globe, retail outflows accelerated to $1.5 billion, according to Lipper, the most since August 2011.
Anecdotally, managers say institutional investors have also pulled in their horns with regard to credit allocations, including loans and commingled accounts. The factors at work here are the same as in the retail space, where a drumbeat of negative press and duration fatigue has led pension funds and other institutional accounts to adopt a more guarded posture.
With technical support flagging, the average price of S&P/LSTA Index loans fell 0.39 points in July, to a three-month low of 98.63, from 99.01 at the end of June. The damage was felt mostly at month-end, with the average Index bid trading off 0.24 points during the final week of July. The pain continued in early August, with the average bid off another 0.24 points during the first five trading days of the month, to 98.39.
The damage was more severe still among the large loans that constitute the S&P/LSTA Loan 100. The average bid for this sub-Index fell 0.56 points in July before trading off another 0.32 points by Aug. 7. Selling by high-yield accounts – which suffered $5.4 billion of outflows during July, according to Lipper FMI – further pressured loan prices during the waning days of July and into early August, putting pressure on large, liquid issues, participants say.
In the primary market, the impact of eroding technicals lagged, as usual. In fact, new-issue clearing yields were effectively unchanged in July as flexes once again favored issuers by a count of 26 to 17. Though this reading is far less lopsided than June’s score of 46 to 12, it still kept clearing yields in a box.
Still, the secondary market’s anemia began to infect the primary in the final week of July and the first week of August. Flex activity, for instance, shifted into neutral, with arrangers sweetening and tightening an equal number of loans – eight – between July 28 and Aug. 8. In response, new-issue clearing yields widened by roughly 18 bps during the first reading of August versus June’s levels. Loans to single-B issuers, for example, printed at an all-in yield of 5.6%, versus 5.32% in June.
These data, however, don’t capture the new reality in the loan market. Several deals are unofficially talked at substantially wider levels, with other-investor friendly changes in the works.
And those are the deals that make it across the finish line. After a mini-spike in repricing activity during the first three weeks of July, three such transactions – Paradigm, SeaStar Solutions, and Blackboard – fell victim to softener demand during the past two weeks.
The carnage wasn’t just limited to repricings. HCP Global withdrew a dividend recapitalization deal, and Red Rooster QSR canceled its proposed refinancing. Perhaps most notably, Styrolution’s M&A-related execution, which was being arranged on a best-efforts basis, was shelved until a later date due to market conditions.
Looking ahead, most players expect the negative bias to persist in August as the market digests the recent supply and the outsized outflows from both loan and high-yield accounts.
With arrangers unleashing a couple of gorillas on the market in recent weeks – such as the nearly $4.6 billion Albertsons M&A financing and $7.4 billion of new term loans from Charter Communications – the forward calendar of M&A-related loans stood at $40.2 billion on Aug. 7, which is toward the wide end of the year-to-date band.
Parenthetically, participants say that jumbo deals like these, which need support beyond the CLO community to clear, likely will require a decent premium to bring along retail players who are contending with week after week of outflows.
Further out, the picture is murky. Arrangers say screening activity is robust, suggesting that new deal flow will continue apace when the market reopens after Labor Day. At the same time, retail investors continue to keep their distance from loans and high-yield bonds, exerting pressure on both asset classes. With that in mind, players expect pressure to persist on secondary prices, which in turn could keep the CLO engine humming during the final stretch of 2014.
Of course, a disruptive outside shock could send prices lower. Given all of the geopolitical hot spots around the globe, this is not an idle risk. Still, there is also the potential for an upside scenario, in which the pace of economic growth builds from the second quarter’s stronger-than-expected 4.0% figure. If so, expectations for rising rates will undoubtedly grow, which in turn could reignite retail inflows to the asset class. Of course, even if retail investors return to the loan market, any potential price appreciation is limited, given that the average Index price stood at 98.39 on Aug. 7.
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