A confluence of events is encouraging banks to sell--and investors to buy--a wide range of innovative and esoteric products that include second-lien loans, derivatives referencing high-yield bank debt, middle-market loans and even a "B" loan that finances a power plant. "You need stable-to-rising markets to roll out these types of innovative products. You also need liquidity in the market and money has recently been pouring into the prime-rate funds as well as into loan products in general," said Jonathan Lavine, managing director and cio of Sankaty Advisors.
The biggest development has been the growth in second-lien loans. Last year, there were $4.5 billion of second-lien loans and bankers are predicting that issuance this year will soon break through that level. "There has been a complete explosion of the second-lien instrument as the investor base has broadened," explained Richard Carey, a managing director with Credit Suisse First Boston. "The hedge fund community and regular par buyers are seeking yield in an otherwise declining credit spread environment," he said.
Fred Engel, a senior structurer in global credit derivatives at UBS, explained that the demand for assets and spread compression is a big part of the equation in persuading investors to look at different opportunities. "In these tight markets there is more emphasis on everyone's radar screen to try to make sure they are not leaving anything on the table. Managers want to make sure if there is an asset class that makes sense for them, to now spend a little more time making sure their vehicles can incorporate or take advantage of it," he said.
This hunt for yield is propelling banks and investors in new directions. Citibank is reported to be working with a number of institutions to structure synthetic loan-products using credit derivatives and CSFB has launched a synthetic index of leveraged loans constructed as a credit derivative dubbed the Select Aggregate Market Index or SAMI. CSFB is also launching a $690 million facility to fund the construction of a power plant in Queens, the first time "B" loan investors have taken on construction risk (LMW, 3/8). "The overall size of the institutional market and number of investors' means we can show more types of offerings than in the past," said CSFB's Carey.
Give Them Credit
But there are also advances that go beyond the necessity of putting cash to work. "Our perception is that banks and institutions are looking for ways to slice and dice their balance sheet as well as adjust their exposure in more frequent and subtle ways than they had before," said Lavine. "The credit default swap market is offering some of the most interesting possibilities." As these develop, they will add liquidity to the market, he said. "Today, the bank loan market is basically a long-only market. As the credit default swap market develops through both single-name and index products, funds will for the first time be able to participate in the bank loan market on the short side."
If the advances in derivatives continue this could have far wider implications. Sankaty would be interested to see this lead to the use of credit default swaps as a way to syndicate revolvers, Lavine said. Many funds structurally cannot own a revolver, but they can own CDS. "I could foresee banks underwriting revolvers and rather than syndicating them, distributing their risk through the use of CDS. This inherently increases the number of potential buyers of revolvers, thus improving liquidity in the market. That would be a big positive," Lavine concluded.