Given the growing importance of the secondary market for syndicated loans, the authors seek to quantify the initial borrowing costs of loan issuers owing to the probability of loan resales. They show that borrowers that are willing and able to participate in the secondary market are able to reduce net borrowing costs in the primary market by 14 bps.
The authors show that syndicate lenders offer price concessions to non-investment-grade borrowers that are willing and able to participate in the secondary market. But although loan resales increase liquidity in the secondary market, the obligation of oversight leads banks to adopt an originate-and-distribute model, which increases risks to potential investors. The authors reconcile the disparate effects (increased liquidity but decreased bank oversight) of these two actions and find that, overall, the loan resale market has lowered costs for non-investment-grade borrowers. Interestingly, the authors do not find similar cost concessions for investment-grade borrowers; instead, they find that loan resales increase costs to borrowers.
How Is This Research Useful to Practitioners?
The authors test two hypotheses to help quantify the costs and benefits of the secondary loan market—the price concession hypothesis and the diminished monitoring hypothesis—in an effort to understand the net benefit to borrowers willing and able to participate in the secondary market.
Because increased liquidity from loan resales benefits lenders, the authors posit that banks may offer lower spreads to liquid loans (i.e., the price concession hypothesis). To test this hypothesis, they use constraints on resales, implemented by loan covenants that require borrower consent, as a proxy for the willingness of the borrower to participate in the secondary market. More (less) restrictive consent constraints mean the borrower is less (more) willing to participate, which is factored into the initial borrowing costs. The authors find that borrowers with more restricted loan covenants increase the yield spread by 37 bps.
Conversely, direct loan sales through the secondary market largely absolve bank underwriters from continued monitoring and transform their role into that of originator and distributor. The authors suggest that the resulting increased risk may be associated with higher borrowing costs (i.e., the diminished monitoring hypothesis). They estimate the probability of loan resale and of loan resale constraints and then use these forecast probabilities to explain the ex ante loan yield spread. Consistent with their expectations, the authors show that the ex ante probability of loan resale dramatically affects the primary market loan spread. This impact on the primary market is larger than the effect of the ex ante risks and other characteristics of the borrowers; it raises the spread by roughly 55 bps.
Overall, the benefits of liquidity outweigh the costs of reduced monitoring, and on average, the existence of the secondary loan market lowers borrowing costs. The authors find that the average net impact of simultaneously reducing the probability of the presence of resale constraints and raising the probability of resale across the full sample is a 14 bp decrease in the spread.
How Did the Authors Conduct This Research?
Because syndicate underwritings occur prior to secondary market trading, the authors estimate the probability of loan resale and of loan resale constraints for each loan facility using only ex ante information and then use the forecast probability of resale and of resale constraints to explain the ex ante loan yield spread. They identify the secondary market feedback variable—the probability of loan resale—as a proxy for lenders’ monitoring incentives. Restrictive covenants stipulate that the borrower’s permission is required for loan resale, and the authors treat such covenants as a proxy for loan liquidity. As a result, they are able to separate the costs (diminished monitoring) from the benefits (greater liquidity) of secondary loan resales.
To thoroughly test their hypotheses, the authors use a sample that includes all US loan facilities extended to public companies in the Dealscan database from 1994 to 2004. The secondary market-to-market loan pricing data are obtained from Loan Syndications & Trading Association and Thomson Reuters LPC. This database includes daily quotes of 5,101 loan facilities through 2004, with the earliest loan originations traced back to 1994. After excluding observations with missing values of control variables, the sample available for regression analysis is composed of 10,992 loan facilities, of which 1,012 are loans that are resold.
The secondary loan market has grown from $8 billion in 1991 to more than $400 billion in 2010. As such, the loan market has become a viable investment opportunity for many investors. Understanding the incentives (price concessions) in place for borrowers to continue to access the secondary market is important to determine whether, at a minimum, the loan market is an appropriate place to allocate capital.
The authors conduct an impressive amount of research; many of their findings support the hypothesis that lenders offer price concessions to borrowers that allow the syndicate underwriters to eventually resell loans into the secondary market. But the authors state that this phenomenon exists only for non-investment-grade borrowers in general and the highest-risk loans specifically, which suggests that the secondary market has benefited the most from these potentially troubled credits. As such, (potential) investors in the secondary loan market should remember that initial yield spreads may not fully reflect the true risk profile of stressed borrowers given the disproportionate desire for the syndicate underwriters to offload these loans.