Loan price falls spurred by Icelandic asset sales

Risky corporate loan prices have been hit hard after a flood of sales by Icelandic banks and hedge funds who have had funding lines for their holdings pulled, further disrupting a market used by ordinary borrowers and private equity buy-out groups.

Loan prices have breached new lows in recent weeks as the financial crisis has intensified, but in the past few days the fall has accelerated.

The average price of the most traded European leveraged loans has fallen to about 80 per cent of face value, down from 84 per cent last week. This implies that creditors to those companies would risk losing 20 per cent of their investment.

The US market has seen similar falls in pricing. Earlier this week the average bid for the most traded US leveraged loans was 74.62 per cent, down from the previous week, according to Standard & Poor's Leveraged Commentary and Data.

The collapse in leveraged loan prices could have wide-ranging effects. It will not only make it more expensive for junk-rated corporate borrowers to refinance debt, but also continue to hinder the ability of private equity funds to finance corporate buyouts. For investors that mark their portfolios to market, it also means losses.

Barclays Capital this week requested bids on a $660m portfolio of European leveraged loans, which had been held by Landsbanki, which was nationalised earlier this week. The sale was triggered by the unwinding of a so-called total return swap, a form of financing typically used by hedge funds to invest leveraged loans. Landsbanki declined to comment.

Investors talk of further sales, adding to the pressure. Royal Bank of Scotland was asking for bids on a list of leveraged loans also held on behalf of an Icelandic bank.

But the wave of selling is global. Last week GMAC failed to sell a $2.7bn portfolio of loans as conditions across the credit markets continued to deteriorate.

The loans sales are the latest wave in a massive deleveraging of the financial system where financial institutions and hedge funds are selling assets to raise necessary cash. "There has been selling from bank portfolios, including Lehman Brothers on the day of its bankruptcy filing, and a lot of redemptions in the hedge fund space that require raising some capital," said Chris Taggert, a loan analyst at CreditSights.

As prices fall, it triggers further unwinding of other market-value linked financing lines or investment vehicles, creating a downward spiral in pricing. The market saw similar events in February this year, when leverage loan prices reached record lows. But after the rescue of Bear Stearns, buyers stepped in stemming the price falls.

However the worry for some investors now is that continuing concern about the stability of the financial system is keeping buyers on the sidelines. "There have been a string of bid lists out to the market and we don't know how many more will come," said Frits Prakke, managing director of Alchemy special opportunities fund. "What this does is revealing what value investors really believe these loans are worth. Many people say these loans are too cheap but they are not once you model the company and its capital structure, in the context of what will be a deep and nasty recession."

Matthew Craston, joint head of leveraged loans at European Credit Management says most of these loans are currently undervalued. "Refinancings will be more difficult and expensive. However one saving grace is that all private equity backed companies have long term financing."

He believes events also highlight the risk that credit rating agency forecasts of default rates may be too low. "S&P forecasts about 25 per cent cumulative defaults over the next three years, which we believe is a fairytale outcome."

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