Institutional Demand Pressure and the Cost of Leveraged Loans

Abstract:     
Between 2001 and 2007, annual institutional investment in highly leveraged loans dramatically increased from $32 billion to $426 billion, an increase that accounted for nearly 70 percent of the jump in total syndicated loan issuance over the same period. This paper asks the question if the inflow of institutional funding leads to a contraction of loan spreads. To understand this relationship, we look at the demand pressure defined as the number of days a loan remains unsold. Using market-level and cross-sectional variation in time-on-the-market, we find that a shorter syndication period is associated with a lower final interest rate. This relationship is robust in the presence of institutional fund flow as an instrument. Furthermore, we find significant price differences between institutional investors’ tranches and banks’ tranches of the same loans, even though they share the same underlying fundamentals. Increasing demand pressure causes the rate on institutional tranches to fall below the interest rate on bank tranches. Overall, a one standard deviation reduction in average time-on-the-market decreases institutional loan spreads by over 34 basis points per annum. This effect is significantly larger for loan tranches bought by structured investment vehicles (CDOs) but is not fully explained by their role.

Keywords: Institutional investors, syndicated loans, LBO, credit crisis

JEL Classifications: G11, G14, G21, G22, G23

Working Paper Series