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By Ronald Fink
Highly leveraged companies face increased borrowing costs as a wave of loan packages that fueled the buyout boom comes up for renewal, according to a report published on Tuesday.
Banks packaged and sold off to investors most of the loans they made to private-equity funds earlier this decade to finance leveraged buyouts. But a rapidly growing proportion of the collateralized loan obligations the loans were packaged into are set to mature in the next few years, and many borrowers cannot meet the investors' conditions for extending them, the report by research firm CreditSights said.
At the end of the 10-year term that's typical for CLOs, their covenants become more restrictive, forcing borrowers to meet tougher terms for such items as interest coverage, collateral and credit ratings. And that's helped fuel high-yield bond issuance during the past year, as many companies anticipating the end of a CLO tranche that includes their loans have turned to the public bond markets for refinancing. This phenomenon has come to be known as "extend and pretend" when the proceeds aren't used to pay down debt.
"One of the driving forces behind this trend is the end of the reinvestment period for the CLO universe," observed CreditSights analyst Chris Taggert in the report.
But Taggert added that the trend could be difficult to sustain if too many borrowers fail to meet the conditions for CLO reinvestment and have to repay principal.
"The post reinvestment period essentially amounts to one broad-based outcome," he noted. "Principal proceeds will be heavily directed toward the repayment of liability tranches versus redeployment back into the loan market."
At present, roughly 35 percent to 50 percent of U.S. and European CLOs, respectively, are not in compliance with at least one coverage test metric, Taggert noted. And 86 percent of U.S. and 84 percent of European CLO tranches were downgraded by Moody's Investor Service in February 2009, with 95 percent of all CLOs experiencing at least one downgrade.
As a result, borrowers face "multiple headwinds to the redeployment of capital back into the loan market for CLOs," the analyst wrote. And he doesn't expect that to change any time soon.
"While CLO issuance will gradually resume, it will be insufficient to sustain the current size of the CLO universe," Taggert wrote. "This is not a good situation for borrowers or CLO managers."
As more issuers to turn to the bond market for fresh financing, the resulting increase in supply could weigh on prices.
In an interview with CFOZone, Taggert noted that much depended on investor demand for such bonds. "That's a tough call," he said. But while demand for them so far has been strong, the analyst noted that a growing number of high-yield issuers have been forced recently to issue secured bonds, which currently can be three times as expensive as bank loans.
And while covenants of new secured debt may be relatively loose, he said investors may be in for nasty surprises there.
In another report last November, the analyst noted that the market may be mispricing such bonds. "Today's covenants are setting up prices for potential steep drops at the time a covenant driven credit negative action is taken."
In fact, spreads between yields on Treasuries and those on junk bonds have recently widened considerably, suggesting investors are starting to anticipate such actions.
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