The Deal: Leveraged Loans Are Being Issued Like It's 2007

NEW YORK ( The Deal) -- If happiness is health and a short memory, no wonder the debt markets are so happy.

A healthy economy and a lowered default rate have led to a record issuance of leveraged loans, which hearkens back to the good old or bad old -- depending on perspective -- days of 2007, not long before credit markets seized up.

Through the third quarter of this year, total loan volume is $515 billion, according to a JPMorgan report. That compares to the prior record of 2007, when the total for the entire year was $388 billion.

September alone hit $45.8 billion on the back of two of the biggest leveraged loans ever: Hilton Worldwide Holdings and Dell ( DELL) with both breaking the $7 billion mark. These two deals, along with a $9.5 billion loan package backing H.J. Heinz Co.'s $28 billion buyout, represented the first time loans have reached pre-crisis levels. No loans above $6 billion had been issued since 2007, according to Standard & Poor's Leveraged Commentary & Data

Happy debt markets indeed. However, for investors with memories of the great recession, perhaps not so happy. Less than three years after prior record loan volumes hit the books, the default rate on corporate leveraged loans also hit its own all-time high, topping out at around 14% in 2009. This was even higher than the bond default rate, which traditionally had been higher than that for loans.

Coincidentally, the loan default rate hit a three-year high during the third quarter of 2013, climbing to 1.94% from 1.79%, the highest it has been since November 2010 when it was at 2.18%.

While these numbers are still low from a historical perspective, investors would be permitted to worry whether history was about to repeat itself.

But this time may be different, particularly because there has been a big change in leverage ratio.

"I don't think that volume itself is indicative of there being a greater risk of default," says Patrick Ryan, head of the banking and credit practice at Simpson Thacher & Bartlett. "In addition, leverage levels haven't returned to the multiples you were seeing in 2006 and 2007."

Many companies before the credit crisis were leveraging up to between 7 times and or 8 times and sometimes even higher. Ryan said he has not seen ratios near that now typically. Even the Dell LBO was only leveraged up about 6 times. (Which didn't keep Carl Icahn from squawking about the deal.)

Another big change is a company's reasons for issuing this kind of debt. Prior to the credit crisis, much of the leveraged loan action came from M&A. In 2008, 56% of the loans were the result of LBOs; in 2009, it got as high as 74%.

So far in 2013 the percentage ascribed to M&A is only 18.3%, with the rest used for refinancing and repricing debt. In some cases, companies are taking advantage of low rates to refinance loans they had refinanced only a year ago. With interest rates likely to begin to rise once the Federal Reserve finally begins to cut back on asset purchases, Ryan says, at some point, the loan market will cool down too.

This summer, when Fed Chairman Benjamin Bernanke said the central bank might move to pull back, 10-year Treasury yields doubled to nearly 3% within the space of less than two months. But in September, the Fed -- concerned about a still fragile recovery -- said it would put off that move, sending yields down to about 2.6%.

Demand from investors could also be pushing up the volume in leveraged loans, because this kind of debt fluctuates with interest rates.

"The loan market as a variable interest rate market may be perceived as a good hedge for some investors with the Fed talking about tapering and the prospect that we may be entering an increasing interest rate environment," Ryan says.

John Cokinos, head of Leveraged Finance Capital Markets & Syndicate at Bank of America Merrill Lynch ( BAC), points to three growth investment areas that have lead to strong demand for leveraged loans: retail loan funds, separately managed accounts for institutions and collateralized loan obligations.

Loan funds have seen inflows for more than 60 consecutive weeks, capped by 38 straight weeks of inflows exceeding $700 million, a streak that is still going strong. Retail inflows are $52.3 billion year-to-date. To put this in perspective, the prior record for retail loan inflows is just $17.9 billion, which was set in 2010. Last year, inflows totaled $12.1 billion.

This is all despite the fact that M&A still hasn't hit its stride.

U.S. M&A totaled $853.7 billion for the first three quarters, which was up 37% over last year, according to Dealogic. This was thanks in large part to Verizon Communication Inc.'s ( VZ) $130 billion deal to buy back Vodafone Group's ( VOD) part of their JV in Verizon Wireless, as well as the Dell and Heinz LBOs. However, the number of deals dropped 21% year-over-year to 7,117.

"The pace of M&A activity hasn't accelerated to the point that people might have expected, as auction activity remains relatively weak," Ryan says. "In addition, some private equity sponsors appear to be taking a relatively conservative approach on valuations while they wait to see how some of the issues in the macro-economic market play out."

With the right company's story, "there won't be a hard cap within reason on the amount of debt that can be raised as we have seen some large acquisition financings this year," said Ryan.

Still, companies could be borrowing trouble, especially if banks allow leverage to creep back up to higher levels.

At the same time, the latest in leveraged loan flavor has tended toward the covenant-lite, which helps keep the default rate low. As Ryan explains, "If there aren't any financial covenants to breach, companies will have a longer runway to restructure before a refinancing is required."

In the 2013 third quarter, 64% of loans issued were covenant-lite, beating out the prior record of 58% set during the second quarter, according to S&P's LCD.

As long as the default levels remain low, the debt markets should remain very, very happy.

Written by Jonathan Schwarzberg

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