LONDON, Feb 28 (Reuters) - Europe’s secondary loan market has peaked at an all-time high with the composite reaching 100.94 this month, according to Thomson Reuters LPC data, fuelled by a supply-demand imbalance that is affecting banks as traders take hits to cover costly shorts.
Europe’s leveraged loan market has been flooded with liquidity from a series of new CLOs, warehouses, managed accounts and a bout of repayments. But with very little new primary supply, investors have been forced to buy paper on the secondary loan market, pushing prices higher.
“Secondary prices have risen to extremely high levels due to supply and demand - it is no more scientific than that. There is not enough new paper in the market to satisfy the amount of cash knocking around,” an investor said.
At 100.94 on February 2, Europe’s top 40 leveraged loans hit a high not even seen before the financial crisis. The closest the composite had previously reached was 100.72 on April 20 2007, according to TRLPC data.
The unprecedented bid levels are catching out a number of traders, who agreed to sell paper to investors at a certain price but are finding they can only source the loans at higher levels, contradicting expectations they could find the paper at lower levels and book a profit on the difference.
“Everyone is desperate for paper and trying to provide liquidity to the market is very difficult. If you are able to and you do short, when the market goes like this, you can get into a right pickle,” a loan trader said.
Shorting individual credits in the loan market is a long-established practice, given the long settlement process. While some shorts have gone wrong previously, it is now becoming widespread as traders book losses against the wholesale increase in loan pricing.
With many sales agreed in December and January, traders are now attempting to cover a series of shorts, which is also pushing prices higher as potential sellers take advantage of traders scrambling to honour trades.
“There is a natural ability to short loans because of the clunky nature of settlements. No one realised the market would go as high as it has and the desperate plight of traders to find the paper they have shorted is now pushing prices up even further,” a second loan trader said.
In some instances, traders are unable to source the paper they have shorted, which has led to the trade being pulled altogether.
“Somebody shorted something which was very foolish as they couldn’t source it, so they had to rip up the trade in the end. The paper was smuggled away into CLOs that are so desperate for loans that they wouldn’t sell, no matter the price. It is very unusual and has never happened before to this buyer. It is a new development and now there is the question of how to deal with this new concept,” a second investor said.
Traders are mainly booking shorts of around one to two points, equating to a 1%-2% loss on a trade. A series of these could see some hefty losses for banks.
“One percent of a €10m trade is €100k. That isn’t going to have much effect, but if you’ve done 10 of these shorts, that’s a loss of €1m on the books. That will have an impact,” a third investor said.
British holiday park operator Parkdean Resorts’ £575m term loan B, which backs the company’s buyout by Onex, allocated with an OID of 99.5 on February 9. It broke at par and was quoted at 101.6 on February 28. French call centre operator Webhelp’s repriced €560m TLB2 allocated at par on January 12, and was quoted at 101.25 on the break and 101.4 on February 28, according to TRLPC data.
Even more tricky credits are on the rise in this market. Israeli furniture maker Keter’s €320m add-on term loan B3, backing its acquisition of Italian peer ABM Italia, allocated with a 97 OID on February 9 and was quoted at 97.46 on the break, rising to 100.6 on February 28, TRLPC data shows.
A lack of supply in a liquid market and a rise in secondary prices have led borrowers to raise additional debt for bolt-on acquisitions and reprice existing portfolio companies on more attractive terms.
These deals are offered with 101 soft call for six months, helping loans to trade higher on secondary as soon as they break, as investors feel confident the loans are unable to reprice and return to par, without the borrower paying a hefty break fee.
Soft call wasn’t offered before the financial crisis, helping current prices to peak to levels not seen before.
“Pre-financial crisis loans were not offered with call protection, so on the break they only rose a little. When deals get done today, they are offered with soft call so there is scope for them to trade up,” the first investor said.
The relentless upward trajectory of loan pricing is set to continue unless new supply comes to the market or an unknown and shocking geopolitical or economic event occurs.
As a private market, European secondary loans are more insulated to wider macro events than other capital markets. Despite taking a bit of a hit after the Brexit referendum and Trump’s election win, the market bounced back within a few days and few hours, respectively. (Editing by Christopher Mangham)