early Q4 of 2010, we will likely begin to
see a modest increase in interest rates
as the word “inflation” begins to appear
in the economic discussion. However,
the Fed tends to be patient and will
probably wait to see improvement in
consumer spending, favorable employment statistics and a rebound in housing
starts before increasing interest rates.
What will happen in the high-yield
market?
The high-yield market had a banner 2009,
with returns on high-yield bonds near
50% for the year. A rally from distressed
prices largely drove the returns, with
prices of high-yield bonds appreciating
from lows of close to $60 in late 2008 to
the upper $90s by the end of 2009. One
of the key drivers of high-yield demand
in 2009 was the long drought in high-yield bond issuances in recent years,
which was caused by the growth of the
leveraged loan market over the past
decade. As syndicated loan issuances
increased and demand for structured
assets such as collateralized loan
obligations (CLOs) increased, high-yield
bond issuances dropped off.
However, money moved back into
high-yield mutual funds in 2009, increasing demand for these bonds. In response
to this demand, high-yield issuances
in 2009 were more than triple those
of 2008, with a number of structural
changes taking place: Original issue discounts (OIDs) to increase yields became
commonplace, the issuance of secured
notes increased to retire secured loans
and maturities and durations on new
high-yield issuances fell from an average
of 7–10 years to 5–7 years.
In 2010, high-yield issuance is likely
to continue at elevated levels for a
number of reasons, including the
continued refinancing of leveraged
loans with high-yield bonds, large
sums of capital shifting from lower-yielding assets to higher-yielding
assets as investor risk tolerances
increase, and an increase in M&A and
LBO activity. Investors are likely to
continue to shift toward riskier asset
classes in search of yield.
Returns on high-yield bonds in 2010
are likely to range from 10% to 14%,
driven primarily by coupon interest
payments rather than by the price
appreciation that fueled the stellar
returns in 2009. The recovery from
distressed prices has already largely
taken place and OIDs on new issuances
have been shrinking, a trend that will
continue. There may still be, however,
some room for price improvement. The
spread on high-yield bonds implies a
default rate higher than the worst period of cumulative defaults (1987–1992)
in history. Further spread compression
could help the high-yield market continue to perform well in 2010.
What can we expect from the leveraged
loan market?
As was the case with high-yield bonds,
leveraged loans offered returns in
excess of 50% in 2009 because unprecedented low prices in late 2008 recovered
to the low-to-mid 90s by the end of 2009.
Meanwhile, new borrowers were forced
to offer additional incentives in order
to attract capital, including significant
OIDs and LIBOR floors. New issuances of
leveraged loans, however, dropped off
significantly in 2009 as corporate issuers
extended debt maturities by refinancing
their loans with high-yield bonds.
Although high-yield bonds will
continue to displace leveraged loans in
2010, primary issuances should increase
on an aggregate basis, with the majority
of new issuances driven by refinancing
existing loans and funding needs for
M&A activity. Companies coming out of
bankruptcy with large exit facilities will
fuel additional demand for leveraged
loan issuances. A familiar source from
just a few years ago — collateralized
loan obligations (CLOs) — may fund the
demand for these loans. The $440 billion
market for CLOs disappeared in 2007
but is poised to make a comeback as
market conditions improve. JPMorgan
Chase, Bank of America, Wells Fargo and
Citigroup will all be in the game when
the starting gun fires.
Returns in the leveraged loan market
in 2010 will be much lower than 2009
due to the price recovery from all-time
lows. However, returns in 2010 should be
strong, likely ranging between 7% and
9% and resulting from incentives such
as LIBOR floors and OIDs, which borrowers will continue to include in new
issuances. The potential for double-digit
returns in 2010 will exist, particularly
among lower-priced LBO loans that have
sponsor support, distressed or defaulted
loans that have turnaround potential,
and second-lien term loans for healthy
borrowers with attractive coupons.
An area of the leveraged-loan market that will be particularly attractive
in 2010 is the middle market. Although
the overall leveraged-loan market
returned over 50% in 2009, middle-market loans returned only 33%, marking the first time since 2002 that the
middle market failed to outperform
the broader market. Reasons underlying this discrepancy include the fact
that the market for middle-market
issuances is highly relationship-driven
and more of a club buy-and-hold
strategy effort for many market participants and thus is more resistant to
many of the technical factors of the
broader loan market. Further, middle-market loan deals typically run on a
slower clock and lag those of large-cap
borrowers. Because of this lag, many
middle-market loans continued to
perform in 2009 and were not subject
to the same drop-off in secondary
loan pricing that the broader market
experienced; hence the price recovery
curve was not as steep.
What about the asset-based lending market? What can we expect to see there?
Like the leveraged-finance debt markets,
a coming refinancing tidal wave will
drive the asset-based lending (ABL) market in 2010 and beyond. Pent-up demand,
lack of institutional leverage loans and
money-center banks’ voracious appetites for new assets (due in large part
to their receipt of government stimulus
money) will drive the ABL market to new
highs in 2010. Fewer participants (due
to consolidation at the high and middle
portions of the market) will keep pric-
