Ten years after the crisis, demands for leveraged loan offerings is once again off the charts. Portfolio managers who are seeking rising yields as the Federal Reserve hikes rates have shown unprecedented demand for recent deals, despite repeated warnings that they may be buying "at the wrong time."
Leveraged loans are a type of debt that is offered to an entity that may already have significant amounts of leverage or a poor credit history. As rates move higher, the loans - whose interest rates reference such floating instruments as Libor or Prime - pay out more. As a result, as the Fed tightens the money supply, defaults tend to increase as the interest expenses rise and as the overall cost of capital increases.
Gershon Distenfeld, co-head of fixed income at AllianceBernstein LP and a longtime "skeptic of bank loans" told Bloomberg that a good way to gauge the risk in the loan market is to look at returns when loans price too high. Currently, the average outstanding loan is priced at about 98.5 cents on the dollar. According to Distenfeld's research of market prices between 1992 and 2018, when priced at this level, annual returns are about 2.8% for the following two years - lagging both behind 5 year treasuries and high yield bonds. And yet investors are piling in, hoping for even more generous payments, and oblivious of whether the underlying credit will be viable in a higher interest rate environment.
Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC kept it simpler: "It’s not a good time to be buying bank loans," he stated. He also noted something we have demonstrated on numerous prior occasions: lender protections are worse than usual and there's a smaller pool of creditors to absorb losses, and as covenant protection has never been weaker.
But that hasn’t fazed money managers who have been hungry for these leverage loans. For instance, this week, Blackstone Group tapped the loan market to borrow $9.25 billion in the US and Europe in order to buy out part of Reuters' financial terminal business. The company was inundated with orders "far in excess of supply" for one of the biggest leveraged loan financings of the year.
Carlyle Group experienced similar demand, cutting rates twice on $6.4 billion of loans in order to make its recent acquisition of AkzoNobel Specialty Chemicals, due to a similar influx of demand. These deals help top off a record year for United States leveraged loans: a market now over $1 trillion.
Not only are money managers hungry for these deals, but retail has also been allocating capital to fund these loans. There was $282 million of inflows into ETFs and mutual funds that buy these deals during the week ending September 12. According to Cannaccord, pension funds have also been big buyers of credit products this year. Collateralized loan obligations have also been setting records, with $84 billion worth of them being sold this year.
There is a reason for this demand: so far this year, buying loans has been a great trade. So far in 2018, leveraged loans have gained 3.8% including price movements and interest, compared with a loss of 2.6% for investment-grade U.S. corporate debt and a 2.4% gain for junk bonds. A key driver behind the outperformance are the Fed's rising rates.
And speaking of rates, they will continue going up: next week, the Fed is estimated to continue raising rates. At these times, investors seek out financial products whose prices don’t fall as the Fed's monetary policy tightens. These loans are attractive to investors because they are generally higher up on capital structures than corporate bonds or, obviously, equity. This means they could be the first to get repaid in any type of liquidation scenario.
There is just one problem with this: LCD recently looked at the debt cushion of outstanding loans – the amount of debt in a borrower’s capital structure that is subordinated to the senior loan – and found that, increasingly, today’s cov-lite deals have little or no debt cushion beneath them. This is important because the lack of a debt cushion significantly lessens what an investor will recover on a loan, if that credit defaults.
Nonetheless, the optimists - who usually work for banks with a loan syndicate - are still there. Goldman's Amanda Lynam wrote in a report this week that the market doesn’t seem to be too overextended. Some managers are pushing back on deals when they are too aggressively priced and borrowers have reduced debt levels - two signs that, according to her, the market isn't overheating.
She told Bloomberg: "The risks in the leveraged loan market, broadly, are manageable and not close to an inflection point."
However, just like with any credit cycle, that doesn't mean that risks aren't piling up. Moody's highlighted in July that some borrowers were eliminating loan covenants, a move that could ultimately result in fewer recoveries during the next recession. Moody's predicted that average U.S. first-lien term loan recoveries could fall to 61%, versus their 77% long-term average. For second lien loans, recoveries could be 14%, compared with a 43% historical average.
As a reminder, during the last crisis, it was the hedge funds themselves that became second-lien lenders as many banks were unwilling to take on the credit risk. Some hedge funds even went further down the cap structure, going so far as 3rd liens.
Meanwhile, the biggest risk is that companies have taken on record levels of debt during this credit cycle – a fact that should come as a surprise to nobody. According to Tom Mansley, investment director at GAM Investment, this means that first lien recoveries could drop to as low as 50 cents on the dollar.
He told Bloomberg: "There’s a tremendous supply in the marketplace and at the same time, we’ve definitely seen deteriorating fundamentals. That’s going to lead to low recovery rates going forward."
Other industry experts like Neil Desai, portfolio manager at Highland Capital Management, agree. By year end, he predicts an "...inflection point where the decreased loan issuance pipeline could start to slow down the CLO machine."
And since, in its purest form, loan issuance is a ponzi that only works as long as maturing debt can be rolled into new issuance, such a slow down - or worse, hard stop - could have dire consequences for what is rapidly become the riskest corner of the corporate debt market.