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2017 Primary Market: Records vs. Reality

January 4, 2018 - Well that was one for the record books. Last year’s headline U.S. syndicated lending stats blew through historical highs. When looking at the overall market (including investment grade loans), Thomson Reuters LPC saw U.S. lending top $2.5 trillion for the first time chart_010418vs2 ever. Meanwhile, in the overall leveraged loan space – which TR-LPC and S&P/LCD both measure – TR-LPC tracked $1.4 trillion of lending (up 60% over 2016) and LCD saw $645 billion (up 24%). (The two firms use different collection and calculation methodologies and hence get significantly different results.) TR-LPC and LCD are joined by LevFinInsights when tallying up the institutional market. In that market segment, which is the focus of the remainder of this article, TR-LPC observed $924 billion (up 120%), LCD saw $503 billion (up 49%), and LevFinInsights totaled up $984 billion (for the first time they tracked it).  

These staggering volumes clearly run counter to the headlines that business lending is stagnating. So what is the disconnect? One answer – other than the fact that syndicated loans and business loans are not identical – may be that the business lending statistics reflect changes in loan outstandings, while S&P/LCD, TR-LPC and LevFinInsight’s headline numbers show lending activity.  This lending activity has been comprised mostly of refinancings and repricings which i) inflate the volume stats and ii) erode investor returns. How impactful is this inflation? LCD tracked $400 billion of M&A and other new loans last year – and $540 billion of repricing activity. 

To be fair, that $400 billion of M&A lending is quite significant. In fact, according to TR-LPC numbers, LBO lending totaled $119 billion, the second highest year behind 2007’s $206 billion. But even with these new loans, repayments were a problem. The LSTA Chart of the Weekchart_010418vs3 attempts to show the enormous gap between nominal new lending and actual net new loan supply. Gross lending is reflected in “Priced Loan Volume”, which is represented by the gold bars above the X axis. This ranged from $338 billion in first quarter to $157 billion in third quarter and adds up to LevFinInsights headline $984 billion. But these loans often also repaid existing debt. These “associated repayments” subtracted a total of $737 billion from the priced loan figures, and are represented by the red bars below the X axis. And there were other repayments – for instance, from bond proceeds – which shrank the loan supply volume by another $78 billion (green bars below the X axis). Finally, LevFinInsights estimates there was nearly $10 billion in quarterly amortization payments of existing loans. All told, that $984 billion of priced deals shriveled to $160 billion of net supply (represented by the red line). 

And even that $160 billion might be an optimistic take. The S&P/LSTA Liquid Leveraged Loan Index (LLLI) grew by “just” $72 billion – or 8% – to $959 billion in 2017. On the plus side, that $959 billion is a record level of outstandings. On the negative side, that $72 billion of net supply was well short of investor demand. 

That demand came from unexpected sources. First, as has been widely chronicled, the CLO market overcame a slow start and risk retention headwinds to post nearly $117 billion in new issuance. This nearly doubled most analysts’ forecasts. Conversely, loan mutual fund flows started 2017 strong, then turned negative in the last third of the year. But funds still managed to bring more than $12 billion of demand to the market. Meanwhile, Separately Managed Accounts (SMAs) – while not yet measurable – were estimated to bring several billion dollars of demand a month. Even excluding SMAs, the combined $129 billion of visible demand coming from CLO and loan mutual outstripped the $72 billion of net LLLI supply by nearly $60 billion. 

This had to do some damage – and it did. Pricing (and structure) suffered from the supply-demand imbalance. On the secondary side, the average bid of a loan in the LLI ended 2017 at 98.05, actually three basis points down from where it began the year. But the Index also began the year with 68% of loans priced at par or above – so there just wasn’t much headroom for appreciation. 

Moreover, if a loan edged above par, repricings loomed. LCD tracked $540 billion of repricing activity, through both syndications and amendments. All told, 51% of the loans outstanding in the LLI at the beginning of the year had repriced by the end of it. Moreover, a number were repeat repricers. LevFinInsights reported that nearly half of fourth quarter repricings accrued to lenders that had already reduced their spread at least once this year. (Thank the six-month soft call language for that trend!) 

In addition to repricings, borrowers (reverse) flexed their muscles on new issue spreads.  According to LevFinInsights, 2017 saw 141 upward flexes – and a whopping 480 reverse flexes. Little surprise, then, that spreads on investor portfolios contracted materially. (Indeed, this caused issues for some CLOs, which are governed by weighted average spread tests.) Across the year, the average contractual spread in the LLI fell 55 bps to LIB+341. Today, more than one-quarter of single-B loans have a spread of LIB+300 or less, as compared to 5% at the end of 2016. 

But LIBOR giveth at the same time that spreads taketh away. Three-month LIBOR climbed from just under 1% at the end of 2016 to 1.69% at end of 2017. One-month LIBOR, which many borrowers were selecting, climbed from 0.77% to 1.57% in the same period. As a result, while loan spreads dropped 55 bps (bad for match funded investors), the effective yield on the index edged up from 4.8% in December 2016 to 4.86% in December 2017 (better for total return investors).  All told, having been dragged down somewhat by negative market value returns, the LLLI returned 4.12% in 2017. 

So what is on tap for 2018? JP Morgan sees institutional lending slowing a bit. In 2017, JPM tracked $908 billion of gross lending and $238 billion net new volume. Next year, repricings and refinancings may continue, albeti at a slower pace. In turn, gross volume is expected to drop 25% to $650 billion. However, M&A activity might tick up, leading net new volume to climb marginally to $250 billion. TR-LPC survey respondents agree. Survey respondents expected an average of $318 billion of institutional refis (down more than 40%) and $290 billion of net new institutional lending (down marginally). 

On the return front, with much of the loan market priced at or above par, it may be another “coupon-minus” year. JPM is estimating a 4% total return for loans. Barclays, meanwhile, explained why they thought 2018 may be a “sub-carry” year. Starting with a 1.5% LIBOR (in late November) and 350 bps spread, LIBOR’s rise should add about 40 bps to loans’ return, but that should be offset by about 25 bps from repricings, 50 bps from default leakage and 18 bps from modest price declines. So, net-net, more of the same in 2018.

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