To think it was less than three months ago that we wrote that "leveraged loan demand is off the charts as dangers mount." Since then, a lot has happened in the credit market, with yields and spreads blowing out in credit in a much delayed response to said mounting dangers and turmoil in the equity market, eventually hitting the leveraged loan market too, where as we wrote last week, loan prices have fallen precipitously as loan funds suffered dramatic redemptions in recent days, most notably the Blackstone leverage-loan ETF, SRLN, which last week saw its largest ever one-day outflow since its inception.
Fast forward to today when while credit appears to have found a shaky, tentative floor over the last few days, leveraged loans - which started falling later than other markets this quarter - are still sliding, and as long as funds keep pulling money out, will probably keep falling.
While floating-rate loans tend to track bonds, they are often slower to react both to the upside and downside. Since Oct. 1, loans have lost about 2%, including a 1% drop this month, while both high-yield and investment grade bonds rose slightly. In fact, since we last checked in on the S&P/LSTA lev loan index last week it has fallen another full point, and is now down to 95.4, its lowest price in over two years.
"It’s a bit of a catch up," James Schaeffer, deputy CIO at Aegon Asset Management told Bloomberg. "Aggressiveness - on terms and structure - has created more price volatility than in the high-yield market, now that we’ve seen demand for loans slow a bit."
That's putting it mildly: as we noted last week, JPMorgan had to slash the price on a $210 million loan to 93 cents on the dollar from par to sweeten investor demand and help finance a private jet takeover. This represented one of the steepest discounts seen in the leveraged loan market this year. And with the market on the verge of freezing, the size of the deal was cut by $70 million from the originally targeted amount. Meanwhile, in Europe, the market appears to have already locked up, as three loans were scrapped over the last two weeks. To wit, movie theater chain Vue International withdrew a 833 million pound-equivalent ($1.07 billion) loan sale. While the deal was meant to mostly refinance existing debt, around 100 million pounds was underwritten to finance the company’s acquisition of German group CineStar.
More deals were pulled the prior week when diversified manufacturer Jason Inc. became at least the fourth issuer to scrap a U.S. leveraged loan. Additionally, Perimeter Solutions also pulled its repricing attempt, Ta Chen International scrapped a $250MM term loan set to finance the company’s purchase of a rolling mill, and Algoma Steel withdrew its $300m exit financing. Global University System in November also dropped its dollar repricing.
Worse, there is no sign the pain will end in the near term as there has been a significant exodus from loan mutual funds and ETFs in recent weeks, and the market is braced for more: on Thursday afternoon, Lipper reported that US Loan Funds just saw a record $2.5 billion outflow in the past week.
"Mutual funds may have more room to shed incrementally from here given their level of inflows YTD," Bank of America said in a strategy note.
Citi agreed, saying that "despite the deep sell-off, we expect further weakness ahead. Recent outflows represent a small fraction of the inflows that occurred over the prior two years."
Adding to the pricing pressure, demand from collateralized loan obligations, the biggest and until recently most reliable buyers in the $1.3 trillion leveraged loan market, is rapidly slowing.
"The market is turning for loans and CLOs," said Maggie Wang, an analyst at Citi. "Both markets have struggled as people think the upside is now less because the Fed is getting close to the end of its rate hiking cycle."
The difference between the interest rates on the highest-rated CLO tranches and three-month Libor has hit 121 basis points — the biggest risk premium since February 2017. As recently as November 2017, the spread was 90bp, according to the FT.
Lower-rated CLO tranches have also come under pressure as the spread between double-B tranches and three-month Libor rose 70bp in November to 675bp, the biggest monthly increase since early 2016, Citigroup said.
While many have voiced concerns about the risks inherent in a collapse in the loan market, among them the IMF, Fed, BIS, JPMorgan, Guggenheim, Jeff Gundlach, Howard Marks and countless others, concerns about leveraged lending were highlighted this week when Janet Yellen reiterated warnings that declining underwriting standards for corporate loans could lead to more bankruptcies and prolong the next economic downturn.
But as the FT notes, the current tremors in the CLO market seem more related to diminishing investor appetite than a deterioration of underlying credits. CLO issuance this year has hit a record $125 billion, officially eclipsing the all-time record of $124.1 billion set in 2014.
The recent activity has raised the total size of the CLO market in the U.S. to $600 billion, according to J.P. Morgan, which projects the market to grow to $700 billion by the end of 2019, after expected net issuance of $100 million next year, taking into account maturing CLOs and loans that are paid down.
Such optimism may be misplaced, however, as investors have abruptly curbed their enthusiasm and pulled $1 billion from the asset class for the week ending December 5, bringing outflows since mid-November to $4bn, according to the loan pricing unit at Refinitiv. The last time the leveraged loan market saw such large outflows was three years ago.
“The appeal of floating rate instruments has become less attractive,” said Tracy Chen, head of structured credit at Brandywine Global Investment Management. "The late-cycle credit concern, as well as the Fed’s more dovish tone, may weigh on both leveraged loans and CLOs going into 2019."
Meanwhile, leveraged loans prices continue to slide: as shown above, the S&P/LSTA Leveraged Loan Price index has lost roughly 2 per cent this year and now sits at its lowest level since 2016. The price of Invesco’s Senior Loan ETF, by contrast, has declined 3.5 per cent. Meanwhile, the percentage of leveraged loans trading above par - an indication of demand in the secondary market - has collapsed to almost 0%, down from 70% as recently as two months ago according to Citi.
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But the most vivid example of the freeze in the loan market came late on Thursday, when Bloomberg reported that in a flashback to the events that culminated in the 2008 financial crisis, Wells Fargo and Barclays took the rare step of keeping a $415 million leveraged loan on their books after failing to sell it to investors.
The banks now plan to wait until January to offload the loan they made to help finance Blackstone’s buyout of Ulterra Drilling Technologies, a company that makes bits for oil and gas drilling.
The reason the banks were stuck with hundreds of millions in unwanted paper is because they had agreed to finance the loan whether or not there was enough demand from investors, as the acquisition needed to close by the end of the year. The delayed transaction means the banks will have to bear the risk of the price of the loans falling further, as well as costs associated with holding loans on their books.
The loan market froze for at least this one deal after fund managers were reluctant to buy the loans after oil prices had fallen by around a third since early October, and resulted in the first major E&P bankruptcy in years, when Parker Drilling filed for bankruptcy yesterday as oil prices had fallen too far for its business model to remain viable, sending its bonds crashing.
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With the leveraged loan market freezing up - as outflows accelerate to record levels - the recent weakness has raised concerns that other debt sales currently in the works may be sold at discounts that are so deep underwriters may have to book a loss if they can be sold at all, leading to strong pushback on new debt issuance. This is precisely what happened in late 2007 and early 2008 when underwriters found themselves with pipelines of debt sales that suddenly got blocked, and were forced to take massive haircuts to keep the credit flowing.
Still, optimists remain: "The downdraft in loans has been very orderly thus far," said Chris Mawn, head of the corporate loan business at investment manager CarVal Investors. "We anticipate most managers will keep buying in this market trying to be opportunistic and those who don’t have to sell will just hold."
Also, as a result of the recent selloff, leveraged loans are now returning 1.99% this year and some say they could outperform with a 6% gain in 2019. With the recent sell-off, some analysts say loans are looking cheaper compared to high-yield bonds.
Some CLO investors also remain upbeat, blaming the price deterioration on skittish retail investors and fund managers dialling back risk as the year comes to an end. They argue that a strong US economy is supportive of the market with rating agencies forecasting that company defaults will remain low next year (of course, if we learned anything from 2008 it is that rating agencies, and defaults, follow prices, not the other way around).
“There doesn’t seem to be a theme of sophisticated institutional investors being worried about near-term credit risk at this point,” said Tom Majewski, chief executive at Eagle Point Credit. “If anything, the cheaper prices have started to bring more investors into the market.”
Of course, speaking of flashbacks to 2007/2008 it was just this kind of investor optimism that died last.