Debt Prices Falling

Whether you choose to see it as subprime contagion, repricing of risk, or a temporary correction, prices of debt in various markets are falling, which translates into higher yield requirements.

At RGE Monitor, Nouriel Roubini took note (as we did) of a Fitch report warning of overheated lending practices in the commercial real estate lending sector that bear disconcerting parallels to what we just witnessed in subprimes. Fitch had issued an earlier warning in April, and the market seems to have taken note. As Roubini tells us:

One way to see whether the CMBSs [commercial mortgage backed securities] are under pressure is to look at the CMBX indices provided by Markit. These CMBX indices are the equivalent for commmercial real estate mortgages of the ABX indices where the latter refer to cost of insuring against default on bonds backed by subprime residential mortgages. These indices give you a measure of the cost of insuring against defaults (i.e. CDS protection) in various tranches of subprime RMBSs (the ABX indices) and CMBSs (the CMBX indices).

Here is below a CMBX chart that gives you the CDS spread for a group of relatively low rated CMBSs, i.e. CMBSs with a BB3 rating. As you can see from the chart, in the last month alone the spread has increased from a low of 477 to the current 600. Granted, these are among the risky tranches of RMBS; still even BBB tranches and even single A tranches of CMBSs have recently experienced a sharp and similar spike in CDS spreads.

Is this rise in spread a “contagion” from subprime RMBSs and from the ABX market to RMBSs, and thus to the CMBX indices? That is one interpretation. The better and more ominous interpretation is that markets and investors are already noticing what Fitch just told us, i.e that the riskiness and default risk on such commercial real estate mortgages is significantly rising. So after subprime mortgages and their related RMBS, ABXs and subslime loaded CDOs the next show to drop – in this endless and sometime confusing alphabet soup of credit derivatives – may be commercial mortgages and their related CMBSs and CMBXs…

A Wall Street Journal story today, “Loan Slump May Crimp Buyout Wave,” gives more color to the recent reports of increasing investor reluctance to LBO loans, which have led to hung financings and in some cases, betterment of terms to lenders. While many of the comments in the story are cautiously optimisitic, characterizing the current weakness as a needed correction, the fact remains that there is already a very large volume of debt, over $200 billion, slotted to be funded in coming months. That’s a big overhang for any market, especially a tepid one.

From the Journal:

In a snag that is complicating the deal wave, the market for risky bank loans, which has stood strong even as other markets went through bouts of turmoil the past few years, is hitting speed bumps.

Prices of many corporate loans fell significantly over the past month. Meanwhile, some new loan sales have been seeing lackluster demand from investors, a potential challenge for the corporate buyout boom, which many loans are helping to fund.

In addition to being a challenge to bankers, the losses could be a surprise for small investors that own mutual funds specializing in bank loans as a conservative part of their portfolio.

Returns on these so-called leveraged loans fell to a 26-month low in June, according to Standard & Poor’s Leveraged Commentary & Data. Though the downturn isn’t related to fundamental problems at companies that are responsible for the loans — which are enjoying solid profits and low default rates — it exemplifies the growing uncertainty in markets about the outlook.

“People always counted on the loan market being open when other markets were closed,” says Michael McAdams, president of Four Corners Capital Management, a fixed-income manager in Los Angeles. “But any market that tilts too much in one direction has to have a pullback. This is the ‘pause that refreshes’ and that helps things move forward again.”

Yesterday, loan prices recouped some of their recent losses as stocks rose and junk bonds rebounded. But investors and bankers say concerns linger.

In a report to be released today, Fitch Ratings says investor appetite for leveraged loans “is beginning to show signs of waning,” and cites growing concerns over difficulties in other debt markets, notably the U.S. mortgage market, and the huge amount of debt fund raising being planned by companies.

It isn’t clear if the loan market will be able to absorb more than $200 billion in new issuance that is planned for the coming months. Over half of that will go toward funding buyouts, such as Cerberus Capital Management’s purchase of a majority stake in DaimlerChrysler’s Chrysler Group and Kohlberg Kravis Roberts & Co.’s plan to buy First Data Corp.

Last month, several debt sales were postponed or banks were forced to finance deals from their own pockets because of turbulence in the market. Still, many bankers say they expect to sell the large deals that are coming up.

The $650 billion leveraged loan market is comprised of corporate loans whose credit ratings are below investment-grade, or “junk.” They make up the bulk of LBO financings and are typically secured by hard assets of the companies that issue them, which makes these loans safer than junk bonds, which are often unsecured. Such loans used to be held almost exclusively by banks, but are now often sold to investors much the same way that junk bonds are.

The ebb of this giant market, whose main buyers include mutual funds, insurance companies and managers of debt pools known as collateralized loan obligations, is in some ways related to investor concerns over the troubles in the U.S. housing market.

Unlike subprime borrowers, most corporations aren’t having problems servicing their debt. However, as with mortgage underwriting standards, corporate loan underwriting standards have deteriorated significantly over the past two years, with banks selling investors loans with few or no covenants. Private-equity firms are also pushing companies to take on what some investors see as excessive debt loads.

“We’ve had a lively discussion over contagion, trying to figure out what’s drawing these two effectively unrelated markets together,” says John Addeo, a high-yield fund manager at MFS Investments. “Maybe it’s just an aversion to risk.”

Last month, the near-collapse of two hedge funds managed by Bear Stearns rattled the corporate debt market. The funds made big bets on subprime mortgage-backed securities, but also held some CLOs, which were offered for sale as the hedge funds’ assets were being liquidated. It isn’t clear if the CLOs were actually sold, but the prospect of a fire sale spooked some investors and made them reassess their appetite for riskier corporate debt.

Also playing a role was an index that tracks prices in this market known as the LCDX. It was launched in late May by a company called Markit Group. Since the Bear funds’ problems came to light, that index fell from 100.3 to a low of 96.13 on Wednesday, before rebounding to 97.11 yesterday afternoon. The fall in the index then translated into declines in the prices of many individual loans.

“I don’t think anybody saw this particular impact coming,” says Thomas Ewald, portfolio manager on the AIM Floating Rate Fund.

Though the markets are obscure to many, the events are affecting individual investors. Mutual funds that invest in bank loans have in recent years gained favor as a conservative element in many investor portfolios. Bank-loan funds hold $45.5 billion in assets, according to Morningstar Inc.

In the past month, the average bank-loan mutual fund is down 0.26%, according to Morningstar data. That may not seem like much, but since late 2002, the average bank-loan fund has posted gains in every month except one, Morningstar says.

“For the market to be off like this is surprising people,” says Joseph Welsh, a portfolio manager on the Oppenheimer Senior Floating Rate Fund. “It’s a big deal.”

The steady returns of leveraged loans, and the consistent profits for managers of loan portfolios, over the years led to sometimes indiscriminate buying. That enabled issuers to come to market with loans that paid lower and lower interest rates and also had fewer protections for investors.

The dynamic might be changing. First came a building list of low-quality debt to be issued to finance highly leveraged corporate buyouts. Investors, like pension funds, hedge funds and insurance firms, meanwhile, began requiring higher yields before they would own riskier pieces of CLOs, making it harder for CLO managers to profit. That caution has in turn made managers more conscious of the quality of loans they purchase.

Some $57.6 billion of CLOs were issued in the U.S. during the first half, 37% above last year’s pace. But monthly issuance has slipped since February and is expected to slow in the second half, according to S&P Leveraged Commentary & Data.