Loan derivatives to drive loan pricing: M.Stanley

By Richard Barley

LONDON (Reuters) - The rise of credit derivatives in the leveraged loan market may cause changes in the pricing for underlying loans as investors grow more discriminating about credit quality, a senior leveraged finance banker at Morgan Stanley said on Tuesday.

Simon Parry-Wingfield, European co-head of leveraged finance at the bank (MS.N: Quote, Profile, Research, Stock Buzz), said the growth of leveraged loan credit default swaps (LCDS) would allow more and more investors like collateralized loan obligation funds and hedge funds to get involved in the market.

Increasing liquidity as a result of their activity will then feed through to prices that drive the cost of loans funding private equity funds' leveraged buyouts of companies, he said.

"If we make a market in derivatives on (a) loan, there is no limit to the size," Parry-Wingfield said at the Reuters Investment Banking Summit in London. "On the more liquid names we trade four to five times more in derivative form than we do in cash form."

"One thing that we think that will develop is more credit-based pricing (for loans)," Parry-Wingfield said. "Today ... there is no distinction really between the best credit, a mediocre credit and a weak credit."

DEGREE OF DIFFERENTIATION

The traditional financing for a leveraged buyout (LBO) has involved static loan pricing, with a seven-year term loan A paying a margin of 225 basis points, an eight-year term loan B coming in at 275 basis points and a nine-year term loan C at 325 basis points.

While these levels have declined as demand to lend has built, there is still not the degree of differentiation that is seen in the corporate bond market, where pricing is driven by the relative credit standing of the borrower.

But the availability of prices on LCDSs will mean investors will compare pricing on derivatives and underlying loans in the same sector and make decisions about how to invest based on that, Parry-Wingfield said.

This could lead then to advantages in pricing for those private equity firms who build a track record for good transactions, Parry-Wingfield said. "It could give some sponsors an advantage in auctions."

The LCDS market is still young -- there has been a protracted debate over standardizing contracts that still has not been settled -- but already it has developed to the point where two indexes of default swaps have been launched.

The introduction of those indexes -- the iTraxx LevX family -- is however expected to boost liquidity further, with bankers reporting much increased trading in the two weeks since the LevX senior index was launched.