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NEW YORK, March 24 (Reuters) - Low-rated US buyout loans are pricing with razor thin margins not seen since the financial crisis of 2008 as a dearth of new deals allows companies to dictate terms in a borrower’s market.
B3-rated data center operator Cologix priced a US$300m seven-year first-lien term loan and a US$60m delayed draw term loan at 300bp over Libor on March 10 to help finance its buyout by private equity firm Stonepeak in addition to a $135m second-lien loan at 700bp over Libor.
The deal is being seen as a new pricing benchmark for the credit rating, which is Moody’s lowest credit rating for a first lien loan. S&P rated the Cologix loan at B.
The current round of price cutting, which started in mid 2016 and totaled US$208bn for this year on March 13, started with stronger credits but is now extending to lower-rated companies - which is making some investors nervous.
B3 loans can price as high as 775bp to compensate investors for higher risk, as seen on a US$175m B3/B- loan for automotive supplier Diversified Machine Inc’s buyout in November 2011.
The slump in pricing has erased the pricing differential between B3 credits and higher-rated B2 loans, which is leaving investors questioning why they would lend to riskier lower-rated loans.
"A year ago you could build a portfolio with a spread of 375bp for B2 ratings,” said Farboud Tavangar, a founder of LCM Asset Management. “That 375bp is now really heading toward 275bp. If you were going to go to a B3 profile, you aren't going to get much more spread, so you have to ask what you are getting for that additional risk."
Cologix’s deal is yielding only around 4.15%, well below average levels. Primary yields on B3/B deals in the last three years have averaged 5.8% and 6.1% for B3/B- deals. The yield includes Libor or Libor floors, which generally adds about 75-100bp to coupons.
Despite the slump in pricing, loans are currently valued close to historical averages, taking pricing, Libor and default rates into account, said Beth MacLean, executive vice president and bank loan portfolio manager at PIMCO.
“If you look back in time - and especially when you factor in that we are in a very low default environment - we view the market today as pretty fair,” MacLean said.
The asset class is still attractive to investors as leveraged loans are secured, unlike high-yield bonds, which have seen an even bigger pricing reduction that has closed the spread gap between the two instruments.
The yield differential between leveraged loans and high-yield bonds climbed to 32bp from only 14bp on March 1, according to JP Morgan. The difference was 80bp in early November.
“If you are only getting 25bp more yield, then the loan looks a lot better,” MacLean said. “You get just about the same yield with the protection of secured assets. If I can move up in the capital structure and only give up a bit of spread, that makes a lot of sense.”
Before 2008, loans rated B3 by Moody’s or B/B- by S&P regularly priced at 300bp over Libor or below. Teen clothing retailer Claire’s Stores priced a US$1.45bn term loan in May 2007 at 275bp over Libor to support its buyout by private equity firm Apollo Group.
Silicone based-products maker Momentive Performance Material went even lower and priced a US$525m term loan at 225bp over Libor in December 2006 to back is purchase by Apollo.
B3 pricing soared after the credit crisis. Only one buyout loan has priced below 300bp since then - a US$1.085bn term loan backing third-party claim manager Sedgwick Claims Management Services’ acquisition by private equity firm KKR which priced at 275bp over Libor in 2014.
At that time, investors were piling into loan funds as fears about increasing interest rates spurred demand amid more than a year of consecutive inflows. The Federal Reserve increased interest rates for the third time in March which is driving investors into the asset class again and prompted the rapid collapse in loan pricing.
Loan funds have now seen inflows every week since August 2016 barring one week in November and inflows have averaged US$920.5m in the last four weeks.
"I don't think surprise is the right word,” said Tavangar, referring to the slump in pricing. “It reflects the fact that there is a lot of demand out there." (Reporting by Jonathan Schwarzberg; Editing By Tessa Walsh)