In December last year, we warned investors the leveraged loan market faced a variety of challenges that could conspire to drastically curb liquidity and performance. At the time of writing, US leveraged loan prices were beginning to reflect these headwinds. The fourth quarter did in fact prove to be a difficult quarter for a wide variety of risk assets from a performance and pricing perspective. However, with a very accommodative US Federal Reserve (Fed), credit and equity markets have largely recovered in 2019, leveraged loans included. That being said, the concerns we highlighted have not gone away, and many remain important considerations. In our view it is possible we see a repeat of the Q4 performance.
We believe for those investors that continued to support leveraged loans, who did not respond to these risks last September, the opportunity to reconsider has come knocking for a second time. At current levels, prices are back near peak, having largely reversed the losses experienced in 2018. This “second bite at the cherry” doesn’t happen often in markets.
The leveraged loans market dip
Source: Schroders, June 2019
Carnage as usual
“It’ll be ugly for those companies if the economy slows down and they can’t carry the debt and then restructure it, and then the usual carnage goes on.’’
The above is the (alarming) opinion of Bank of America’s Chief Executive Officer Brian Moynihan, and somewhat aligns with our own concerns. There are four principal challenges for leveraged loans in our view.
1. Is the floating-rate aspect of leveraged loans fueling demand?
Global quantitative easing (QE) reduced the supply of safe and liquid investments; depressing yields and creating an environment for corporations to lever up. Corporate leverage reached all-time highs and investors were driven to other assets, leading to substantial inflows into credit markets.
Leverage loans were a prime beneficiary of the flows into credit risk assets and those flows actually increased as the market began to appreciate the potential for the Fed to increase interest rates. Expectations were that leveraged loans, as floating-rate loans, would offer protection against rising interest rates, and still provide an attractive credit risk premium.
Now however, there is a change in policy that investors must contend with. The Fed’s next move is more likely to cut short term rates than to increase them, and we believe demand is likely to be markedly less, given these products and funds should no longer benefit from rising rate concerns.
As outlined above, leveraged loans received substantial demand from investors with concerns about rising interest rates. Additional demand for leveraged loans comes from the collateralized loan obligations (CLO) market. Investors in CLO notes are also demanding higher risk premiums and this either reduces demand for leveraged loans from CLOs - or increases the required loan spread to facilitate the arbitrage.
Further, a strong source of demand for both leveraged loans and CLO notes has come from Asia. Regulators in Japan are also evaluating the concentrations in these products at some larger financial institutions. As such, the demand structure for leveraged loans is likely to become more challenged.
2. Market conditions
Yield spreads have tightened substantially following Q4 2018. Presumably the main catalyst is the market’s relief that the Fed is likely to remain very accommodative. However, we are again at a point where valuations are near peak, at a time when there remains elevated uncertainty.
Uncertainty exists around global growth, geo-political issues, tariffs and trade, just to name a few. It feels again, even against a backdrop of central bank accommodation, that “priced to perfection” is a theme that demands review. Whilst we are no strangers to a confluence of global risks, we should expect to be compensated for this additional uncertainty.
3. Credit issues
The credit issues for leveraged loans have also not changed over the last six months. In December, we pointed out that given strong demand, the leveraged loan market has more than doubled to over $1.1 trillion, since 2011. Along the way, a material deterioration in loan quality has occurred, as indicated by the rising percentage of “covenant light” loans. This represents a decline in traditional investor protections. As well the incidence of “loan only” issuers in which the senior debt is the only debt (i.e. without any protection from subordinate debts) has also grown substantially.
Along with fewer loan covenants, loan leverage has risen. Further, the debt cushion beneath the average loan has gotten smaller throughout this cycle. This means loan losses - in the event of default – are likely to be higher, especially given the increasing prevalence of loan-only deals, relative to past experience.
4. Market structure
More than 50% of leveraged loans outstanding are held by CLOs, and another 20% are held in US mutual funds. The holdings in US mutual funds are important, because leveraged loans typically settle with a 30-day convention. This is a settlement period not matched for a daily liquid investment in a US mutual fund.
As such, daily liquid funds would need to have some source of liquidity, likely shorter settling securities, to meet the need for daily redemptions.
Recently, we have seen some of these liquid mutual funds own such securities, such as CLO securities, or high yield corporate securities, with a shorter settlement period (2 days), and we are now seeing some selling of these securities with little notice. We believe this indicates that these funds are getting redemptions, and in turn, reducing their liquidity. This, we believe, will impact both CLO spreads and loan spreads creating negative price activity. As this liquidity buffer is eroded, we think many of these funds will be challenged in the ability to generate cash for daily liquidity.
Price declines for leveraged loans have occurred in the post global financial crisis period. The last period of loan price declines occurred as recently as 2016 and was centered on the energy crisis. Defaults for energy company’s loans pressured prices, with the result being a significant decline in value. However, this time around, the price declines have come quickly and are not yet linked to rising default rates.
The case for securitized
We think securitized credit should be viewed as a means to diversify risk exposure away from the QE induced excesses seen in many parts of the corporate credit market, both from a supply and a valuation perspective. It also seems there is a catalyst to begin the rotation now, as liquidity and redemptions from credit programs begin. In our view, investors don’t have the luxury of waiting until the next recession begins.
Within securitized credit there are many different types of consumer asset-backed securities. It is possible to use delinquency data to focus on securities with stronger fundamentals, or use it to limit exposure to less desirable sub-sectors. In addition, ABS also benefits from the ability to be selective in both the type of collateral as well as the degree of structural protection, or credit exposure.
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