Loans may spark credit squeeze: Morgan Stanley

By Walden Siew

NEW YORK (Reuters) - The first signs of stress in the U.S. credit cycle will come from the loan market, which may climb to another record year, according to Morgan Stanley's (MS.N: Quote, Profile, Research, Stock Buzz) chief U.S. credit strategist.

U.S. loan, high-grade and junk bond markets soared to record levels last year as corporations and private equity firms acquired companies using debt. Loan issuance alone rose to $1.67 trillion, the most ever, Reuters Loan Pricing Corp. data showed.

Even with higher interest rates, leveraged buyout activity is unlikely to slow down. A key concern will be loans that are repackaged into structured debt products known as Collateralized Loan Obligations, Morgan Stanley's Greg Peters said at the Reuters Investment Outlook Summit in New York.

"What is driving the markets is the CLO market," Peters said on Monday. "The CLO market could fall under its own weight."

CLOs are grouped by their degree of exposure to default risk to help diversify risk. A drop in demand for these products may be the first crack in debt markets that have proven resilient as default rates remain low, Peters said.

"The economics of doing these transactions are starting to look not that attractive," Peters said. "You have the potential for seeing the whole pyramid start to collapse."

Loans for non-investment grade companies climbed to $612 billion in 2006, surpassing the record $500 billion in 2005, which was double levels seen in 2000.

U.S. high-grade bond issuance also rose to a record $919 billion in 2006, and $150 billion for junk bonds, according to Thomson Financial data.

Even if the Federal Reserve raises interest rates, "it's a non-event from the debt side," Morgan Stanley's Peters said. "I don't think this trend is so easily derailed. Rates in the overall scheme of things is not that important relative to history."

A greater concern is consumer confidence, he said.

Investors should stay away from "BBB"-rated companies and invest in "BB"-rated companies. BB-rated corporate bonds, which are below investment grade, offer greater value and have outperformed their BBB-rated peers for 13 of the last 16 years, he said.