Buying and Selling Loans in the Secondary Market for Profit

On February 11, 2013

Investment analysisA secondary loan market is where primary lenders buy and sell loans with investors and other lenders. The secondary market offers liquidity in loans so that prices are more accurate, assist in the process of packaging more loans by syndicate desks. The secondary market also provides opportunities for investment for those who believe a loan is worth more than the current market price. Secondary markets for many other financial products including payday loans, stocks and bonds are very much established and have been around since the creation of the New York Stock Exchange.

Some can date secondary markets all the way back to when the Buttonwood Agreement was established, back in 1792. The loan market is fairly new compared to other financial products, and has been growing substantially since the early 1990s. Every day more traders seem to want more loan market information as they have become popular vehicles to invest in.

The secondary loan market performance can be followed in trade publication and by following a number of indexes. Indexes generally provide the status as to the health of the overall economy and the general sentiment towards new bond issuance. S&P Leveraged Loan Indexes are weighted syndicated loan indexes that include interest payments, spreads and market weightings. The S&P Leveraged Loan Index (LLI) includes loans produced in the United States backdated to 1997, with calculations that compute daily performance.

The S&P Leveraged Loan 100 Index (LL100) goes back to 2002, and is a tradable index for the U.S. market that looks to follow the daily performance of the market-weighted movement of institutions that are big in leveraged loans. Both of the aforementioned indexes are widely used by traders as they use the indexes as an overall performance indicator, much as an equity trader would use the Dow Industrials or the S&P.

If an institution grants a loan and holds onto it, the lender will generate revenue in the long run, as interest payments are received with the loan being repaid. That said, the asset may not be very liquid if it is not traded that much in the secondary market, however, the lender can still make money simply by holding on to the security. By bringing the loan to the secondary market effectively permits the lender to sell it and make money, generating more funds for investments, further lending and other securities. In the secondary loan market trades tend to occur in large blocks, and usually involve a few investors or an institution that has that sort of capital on hand.

In general, loans are packaged in bundles by lenders, which offers greater diversification if the investor is looking for that characteristic. As opposed to purchasing just one loan security, investors have the opportunity to buy multiple securities, equivalent to the mortgage-backed market. The loan packages are stamped with a rating by an independent agency, which hopefully is good research that allows the retail investor information as to the likelihood that the borrower will return funds. Moreover, it allows investors to have an idea as to what sort of return they should expect, given the level of risk.

Again, as with the mortgage-backed market, most lenders will put together more stable investments along with the risky loans and bundle them together. This allows the lender to put the good with the bad, and is able to sell the more undesirable loans in packages. The secondary market provides liquidity for the loan market and a venue where syndicate desks can value new deals, allowing companies to borrow in this market.

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