Despite market technicals that support higher prices in Markit's North American Leveraged Loan Index (LCDX), negative convexity along with M&A pressure could impact the loan sector in the next few months, said analysts and traders on a Goldman Sachs conference call yesterday (13 April).

Recent M&A activity, such as the merger announcement this week of Mirant Corp and RRI Energy, has also driven spreads tighter in this sector. As a component of LCDX, Mirant will be another name taken away at par, says a trader on the call. The companies plan to close the merger by the end of this year.

Aside from M&A activity, companies initiating note offerings to pay down debt have also contributed to negative convexity currently.

As the trader reminds, "as we trade closer to par in overall pricing of the loan market and indices experience their NAV, or the actual cash component of the index continues to ride higher, there's no more upside left, regardless of the spread for LCDX series 12 or 13, who are going to be so negatively convex."

Still, accounts continue to put money to work in the loan and LCDX space. High yield and loan funds continue to see strong inflows. Last week there was more than US$400m flowing into high yield funds and about US$300m in loans - the highest weekly inflow on record, he says.

"We've seen some accounts come in and buy the (LCDX) index at these high dollar prices. It's not that they wanted to buy but they had to buy; they have to put money to work," he adds.

While money piles into loans as evidenced by the S&P return for loans being up over 5.5% year to date, it makes for an interesting technical in the secondary market as there is no new issue supply (in the cash market), he further says.

Another trader on the call notes that the macro picture has not changed very much despite the dollar price rise in the loan space. The LCDX index and the CDX HY index have both been trading up by about a point lately, whereas the CDX IG index is mostly unchanged. "We expect this trend to continue as people look to go down credit ratings and look to pick up incremental yield," he says.

However, the new bullet LCDX initiative is still a bit slow to start. As the first trader notes, they are finding a reluctance of accounts to buy protection on a 5-year bullet maturity that has a 250bp coupon with the prospect of being orphaned at any time.

KFH