Copying and distributing are prohibited without permission of the publisher.

Watermark

Risk is where the money is

12 Nov 2004

Trading desks have had to be more creative this year to cope with declining volume in the secondary market. Investment grade paper has ceased to flow into the market in the same quantities as in the past, and dealers have looked towards the leveraged, crossover and emerging markets to meet their budgets. Charlie Corbett reports.

Diversification has been the name of the game in the secondary loan market this year. The flow of paper from the investment grade primary market has slumped, forcing traders to look for profits in other arenas, notably leveraged loans and crossover credits.

Competition has also become intense, as more and more secondary trading desks have sprouted up. As a result, bid/offer spreads have narrowed considerably and investment grade loans have become, to all intents and purposes, a par market, where most names trade close to par.

?Five years ago there were less than a handful of desks trading in the secondary market,? says Gordon Craigen, managing director in loan trading and sales at CIBC in London. ?Now there are many more desks and they are all hungry for assets. Bid/offer spreads have narrowed quite a bit.?

Banks have found themselves flush with cash in the first nine months of the year. They are under-lent and keen to shore up their portfolios. Competition for mandates has been intense, pricing has fallen through the floor and covenants have all but disappeared from loan agreements.

Though the volume of lending is overall greater than in 2003, the vast majority of deals have been simple refinancings. There has been hardly any new debt and the much-anticipated revival of deals driven by mergers, acquisitions and other events has failed to materialise.

The secondary market has shrunk as a consequence. Banks have been reluctant to sell down their hard-won assets, so even less paper has flowed through to the secondary market.

?Secondary trading volumes in 2003 were unusually large, driven primarily by the recovery of the telecoms companies and fallen angels,? says Alison Jenkins, head of European near-par trading at Bank of America in London. ?The characteristics of the market are quite different for 2004. The Eu15.5bn Telecom Italia-Olivetti deal provided a major boost to the market in 2003, with its generous pricing and friendly transfer language, but there has been an absence of any real richly priced jumbo deals this year.?

M&A deals scarce
The investment grade deals that have trickled down into the secondary market this year have been snapped up by asset starved funds and bank portfolios.

The Eu16bn acquisition loan for Sanofi-Synthélabo, the French drug company that bought its rival Aventis, broke into the market at the end of July and was greeted with extraordinary demand, pushing it swiftly above par.

As much as Eu500m of the loan was believed to have changed hands in the first week, nearly all of which was sold directly to retail accounts, with less than Eu50m reportedly traded through the Street.

Dealers said there were so few sellers of Sanofi paper that would-be buyers found themselves telephoning the entire list of mandated lead arrangers in the hope of finding someone prepared to sell.

The popularity of Sanofi's paper has been sustained since July and it was still trading well above par when Loan Market Review went to press.

The $4.4bn loan to support Bacardi's acquisition of the Grey Goose Vodka brand has been the latest event-driven new money deal to hit the market.

After much anticipation among dealers, the deal, which was over 100% oversubscribed in primary, hit the market in early October. Demand was so strong that some traders reckoned over Eu250m of paper had changed hands on the first day.

The loan broke into the market in the 99.90-99.95 range, but within days had risen to around 100.10-100.20, where most traders believe it will remain for some time. Such high prices have tended to put off dealers and trade in the paper has tailed off in the last few weeks.

?People aren't prepared to pay the sellers' offer price,? says one loan trader. ?It's become too rich for my blood.?

Leveraged deals fill the void
The shortage of investment grade loans available to trade and the sparse returns on offer have forced dealers to look elsewhere to boost their margins ? especially to the leveraged loan market.

?The slack in corporate issuance has been taken up with leveraged deals,? says Chris Porter, head of loan trading at the Royal Bank of Scotland in London. ?If you look around the trading desks, all of them have tried to shift towards leveraged deals and some towards the distressed markets.?

Leveraged borrowers such as food company United Biscuits and retailer New Look of the UK, Italian vending machine maker Autobar and French retailer Vivarte have all traded well above par this year ? something few loan traders would have predicted this time last year.

Even more remarkably, paper from Grohe, the German bathroom fittings company, traded up to 102 in recent weeks ? the highest level that many dealers have ever seen in the secondary loan market.

Demand has been partly driven by the proliferation of cash rich institutional investors, such as collateralised loan obligations (CLOs), as well as by hedge funds participating more and more in the secondary market.

?It makes more sense for hedge funds to buy a leveraged loan than to deposit their money in a bank,? says Porter. ?The increased liquidity also means they can sell their positions more easily, should a better opportunity arise in the bond market.?

Leveraged loans are now trading over par almost as soon as they hit the market. United Biscuits and Autobar broke free to trade in late September and were greeted with excitement.

United Biscuits' paper changed hands at least 10 times in the first week, with the pro rata tranche trading at 99.50/100.00 and the ?B' loan at 100.50 to 101. Autobar was traded at least six times in its first few days in secondary ? the pro rata tranche at 99.00/99.25 and the combined ?B' and ?C' tranches at 100.25/100.75.

Despite the popularity of leveraged names, however, some dealers have urged caution. ?The risk is that in the current favourable and highly competitive business climate, the market overheats as it tests investors' tolerance for leverage in terms of more aggressively structured transactions,? says David Fewtrell, head of secondary loan trading at HSBC in London. ?There are currently one or two deals heading for syndication that are likely to test credit appetite.?

The debt supporting the buy-out of World Directories ? the yellow pages businesses of Dutch media company VNU ? is one deal that some bankers have warned could be a step too far.

The financing package ? estimated to be Eu1.45bn-Eu1.5bn ? is expected to have an unusually high ratio of non-cash-pay debt to Ebitda, of about 7.4 or 7.5.

When the deal was announced in late September, Fitch Ratings took the unusual step of warning that the package was ?the latest example of an excessively leveraged transaction being offered in the European market.?

Crossover offers healthy gains
Crossover credits are another area that has offered healthy gains for traders. This kind of company, on the cusp of the investment and speculative grades, appeals to investors who are coming down the credit curve in search of yield but who do not want to buy truly leveraged assets.

?The fallen angels were great for the first part of the year, holding two to three points of value for dealers,? says one global head of loan sales and trading. ?Now we are seeing crossover credits like C&C and Halfords coming into the market.?

Besides the Irish drinks maker and UK car parts retailer, Yell, Premier Foods, Valentia Telecommunications and Yoplait are all crossover names that have been traded actively this year.

?As investment grade pricing and issuance have fallen, investors in search of yield have looked increasingly towards the ?rising stars',? says Fewtrell, ?rather than the so-called ?falling angels', in the post-IPO, LBO-recap arena.?

Emerging markets develop
Trading in emerging market loans has also taken off this year. Banks have started to hit their country lending limits, especially for states that remain outside the EU, and are using the secondary market to sell their loans and make space for new primary business.

?Emerging markets is an area of the secondary market that has developed rapidly this year ? it has huge growth potential and offers better yield to maturity than in western Europe,? says James Nisbet, a secondary loan trader at HSBC, who joined the bank in May as part of its drive to develop emerging market secondary loan trading.

Nisbet adds a note of caution, however: ?Investors do need to have a good understanding of the market and need to constantly watch macroeconomic and geopolitical developments.?

The South African Reserve Bank's $1bn three year loan hit the secondary market in August and got a warm reception from traders. As much as $200m of paper traded in the first few days and the loan quickly moved up from 99.70 to 99.90. By the time Loan Market Review went to press it was trading at about par.

There has been brisk trade in loans across the emerging markets this year. In Russia, Vneshtorgbank's $275m loan changed hands just below par at 99.95 in October. Polish Oil and Gas's loan traded in late September in the 99.60s and Turkey's Koçbank recently changed hands in the mid-99s.

A further raft of Turkish bank deals is expected to sail into the secondary market later this year, as dealers believe that lenders will start managing their country limits for Turkey.

Knowledge at a premium
This has been a difficult year in the secondary loan market. Fierce competition, driven by the proliferation of trading desks as well as the increased presence of institutional investors, combined with a chronic lack of investment grade paper flowing down, has obliged traders to look elsewhere to meet their budgets.

?The focus of trading has already shifted from investment grade towards leveraged loans, and this shift is likely to continue as institutional investors become ever more important,? says Charles Pelham, head of syndicated and private debt at Bank of America in London. ?Institutional investors are active portfolio managers, and have been major participants in the secondary market as both buyers and sellers of loans.?

The leveraged, crossover and emerging markets have helped to keep most trading desks busy this year, but in these riskier markets, where yields are admittedly higher, dealers have needed closer market knowledge than ever before in order to pick winners.

?It has been a good year but also a challenging one,? says Fewtrell. ?Banks that focus on, say, purely investment grade will have suffered. Those with a more diverse risk appetite will have fared better.? 

12 Nov 2004