This content is from: Portfolio

Leveraged Loans: Institutional Investors Take a Pass

Leveraged loan arrangers hope to develop a new market among institutional investors, who have been small and reluctant players in this area.

The leveraged loan market is back in gear. The loans — used to finance many a takeover and LBO during the credit boom — went from a record high of $535 billion in 2007 to a record low of $77 billion in 2009, according to Steve Miller, head of trends and analysis at Standard & Poor’s Leveraged Commentary & Data. Volume hit $233 billion last year, just below the historic average of $243 billion. The market is expected to grow again in 2011, although the go-go years are over.

The market faces a big strategic challenge, though. Its traditional buyers — the collateralized loan obligation vehicles that poured money into the sector during the boom — will come to the end of their investment life cycle starting late this year, according to Miller. A new generation of CLO vehicles on the scale of the current one is unlikely to be created. So where will the buyers come from?

Loan arrangers hope to develop a new market among institutional investors, who have been small and reluctant players in this area.

“The great unknown, of course, remains institutional investors,” Miller wrote in his leveraged loan outlook for 2011. “Managers say that despite considerable missionary work over the past two years, the big pension funds and endowments remain bit players.”

It appears that institutions invested $8 billion to $12 billion in the market last year, but Miller says those reports are “anecdotes and hearsay.” That figure could double in 2011 if rates move higher, he says. But even so, it would remain a small percentage of the overall market.

As an asset class, leveraged loans have a certain appeal. They generated a yield of 10.13 percent in 2010, according to an index maintained by S&P and the Loan Syndication and Trading Association. And the default rate is low, having dropped from a high of 10.81 percent in November 2009 to 1.87 percent over the last 13 months. That is well below the average of 3.2 percent, according to Miller. He expects the default rate to remain low, now that many weaker issuers have been washed out of the market and others can refinance loans to avoid near-term maturities. That game can’t be played forever, but a massive spike in defaults isn’t likely.

Meanwhile, the shorter duration of loans might be appealing to institutions as well, Miller says.

Part of the problem may be at institutional investors’ concern about settlement practices in the loan market. Several years ago, the LSTA had to urge its members to make certain that end of day prices were accurate.

It’s possible that institutions will have more interest in leveraged loans as the Fed begins to raise rates, but that might not be until 2012, according to S&P economist David Wyss.

“The good news is that many of the market’s influential players — the LSTA, MARKIT, arranger banks, buy side managers — are focused on the problem,” Miller says. “The bad news is that the light has not yet appeared at the end of the tunnel.”

Related Content