NEW YORK, Feb 21 (Reuters) - U.S. loan investors are chasing yield down the credit curve and snapping up riskier, structurally subordinated second-lien loans and loans for lower-rated companies as interest rates stay low.
Loan investors are taking more risk to buy higher-yielding loans as U.S. leveraged loan pricing crumbles under the weight of demand from investors trying to buy loans to hedge against possible interest rate rises.
Assuming a three-year maturity, leveraged loan yields of 509bp on February 19 are nearly 70bp lower than a year ago, according to JP Morgan’s U.S. Leveraged Loan index.
“Most managers are taking more risk in an attempt to pick up yield,” one loan manager said.
Second-lien loans have a second claim over assets in the event of a default and are structurally subordinated to first-lien loans.
Investors bought nearly $38 billion of junior U.S second-lien loans in 2013, more than double 2012’s volume, according to Thomson Reuters LPC data. So far in 2014, $5.5 billion of second-lien loans have been issued and volume is expected to stay strong.
Technology protection services provider Asurion LLC launched a $1.7 billion second-lien term loan this week which is the largest second-lien tranche since oil and gas company Fieldwood Energy’s $1.725 billion second-lien loan last September.
Fieldwood Energy also priced a $425 million second-lien add-on facility this month, which brings its total second-lien loans to $2.15 billion.
Sedgwick Inc, a provider of technology-enabled claims and productivity management services, priced a $445 million facility and cut pricing on its second-lien term loan to 575bp over Libor in February, which is the tightest pricing on a second-lien term loan this year, after strong investor demand.
Down the curve
Loan and bond issuance for lower-rated companies is rising. Borrowing by riskier B3 rated companies increased to 29 percent of total volume in 2013 compared to 21 percent in 2012, according to a report by Moody’s Investors Service in February.
The volume of debt for companies rated one notch higher at B2 shrank to 39 percent from 45 percent, while B1 issuance was roughly flat at 14 percent last year.
“The market is mostly focused on B2 and B3 CFRs (Corporate Family Ratings), including a notable increase in B3s,” the Moody’s report said.
Riskier loans for lower-rated companies and junior second-lien loans have also benefitted from investors’ ‘risk on’ mentality, but their popularity has pushed yields lower in both cases.
Yields on riskier second-lien loans have fallen faster than safer first-lien loans. Second-lien yields fell 187bp to 909bp from the fourth quarter of 2012 to date while first-lien loans fell 111bp to 483bp in the same period, LPC data shows.
Yields on riskier single-B rated companies have also dropped 70bp to 496bp in the first quarter of 2014 from 566bp in the third quarter of 2013, while yields for safer double B rated companies were flat.
Despite the relentless hunt for yield, investors are showing some restraint and pushing back on deals that are deemed too aggressive or risky.
Chemical company Ineos this month sweetened terms on its $4.1 billion first-lien repricing. Outsourcing services firm iQor also boosted pricing on a new $900 million first-lien, second-lien and revolving credit backing its acquisition of Jabil Circuit Inc’s Aftermarket Services business.
“Push-back has come in earnest,” said a loan investor.
The decision to take more risk is different for retail investors and Collateralised Loan Obligation (CLO) fund investors, sources said. Bank loan mutual funds have to put cash inflows to work regardless of low yields, but CLO investors have to meet minimum spread requirements.
“For broad funds, if you have cash inflows, you’re forced to buy the best relative value loans in the marketplace,” said Steven Oh, co-head of Leveraged Finance at PineBridge Investments.
“If you’re managing CLOs, you have tests that you have to meet for minimum spread. As spreads decline and certain credits go below a threshold level, you’re going to pass on those transactions,” he added.
Falling yields have not stopped heavy inflows into the loan asset class. Leveraged loan inflows into U.S. mutual funds have been positive since mid 2012 and totaled $4.9 billion for the year to date on February 19, according to data from Lipper FMI.
Although leveraged loan yields are falling after repricing and strong investor demand for floating-rate assets, loans are still trading about 20bp wide of historic average spreads on a Libor spread basis.
“Even though spreads are compressing, loans are still a relatively attractive asset class on a risk adjusted basis, just not quite as attractive as three to six months ago,” said Oh.