Super-tight spreads on leveraged loans and sky high bids in the secondary market are causing some collateralized loan obligation managers to sweat as vehicles they manage are getting close to minimum spread tests. "The average spread on new issuance is well under [the minimum]," one loan investor said. "Failing that test is ugly; you can't make any new investments."
The average spread for BB/BB- new issue institutional loans is LIBOR plus 228 basis points and for B "B" loans it is LIBOR plus 284 basis points, according to Standard & Poor's LCD. Those spreads compare to LIBOR plus 300 basis points and LIBOR plus 375 basis points, respectively, a year ago. One loan investor noted managers are facing a double-edged sword. "There are ratings tests and spread tests and it's causing problems on both ends," he said. "As we stretch for more yield or spread, those are lower rated assets so we have problems with our ratings test. There's a clear deterioration in credit quality and stretch on credits."
And there's risk. "Naturally, when you reach further down the credit spectrum you are exposed to a greater level of risk in terms of default and recovery," said Derek McGirt, a senior director with Fitch Ratings. Some CLO managers are using synthetic exposures to indices as a way of avoiding going down the credit spectrum (LMW, 2/16). But one manager noted that buying opportunities are limited for synthetics.
Managers may be worried about loading up on lower-rated deals, but it is not likely to lead to a repeat of the blowup of the late 90s. The overall quality of deals coming to the leveraged loan market seems to be good right now, McGirt stated. "We are nowhere near the frothiness that we saw during the late '90s/early 2000 vintage," he said. "The difference at this point in the credit cycle is that even the lower rated credits are for the most part real businesses with a solid story. Whereas before there was a lot of 'business plan' financing."