Yes — Rising demand has tilted power to borrowers and led to weaker covenants
The leveraged loan market reminds me of swimming off Cape Cod: there are a lot of things to enjoy, but also the danger of sharks, writes Megan Greene.
Leveraged loans, which are extended to corporate borrowers with relatively high debt levels, carry more risk and pay more interest as the US Federal Reserve raises rates. They are secured with underlying collateral and when lenders line up for repayment, leveraged loans are usually given priority over lower rated bonds known as high yield credit. That means there is some protection if the borrower goes bust. Last year, which was generally tough, leveraged loans did better than most assets.
But amid low yields, the leveraged loan market is as crowded as a beach in August. The asset class has more than doubled since 2010 to more than $1tn at the end of 2018. Highly leveraged loan deals (when debt is more than five times earnings before interest, tax, depreciation and amortisation) account for about half of new US corporate debt.
That growth is partly a result of securitisation. Roughly half of investor demand today comes from packaging loans into collateralised loan obligations, or CLOs, and slicing them into different tranches of risk. Rising demand has shifted the balance of power from investors to borrowers, and contributed to a watering down of covenants embedded in loan agreements that traditionally protect investors. According to Moody’s, about 25 per cent of the leveraged loan market was considered “covenant-lite” before the global financial crisis. Now that figure is 80 per cent.
The implications in a downturn could be severe. Covenant-lite lending is like swimming without the ability to spot seals (where there are seals, there are sharks looking to feed). Stricter covenants improve transparency and help investors identify underlying problems with borrowers; now some covenants are so weak that nothing short of insolvency will trigger a default.
If problems finally show up, investors will stampede out of the asset class, creating a systemic liquidity crunch. The Fed’s new dovish tone and forecasts of slower growth may damp demand for CLOs. And if corporate revenues stop rising, over-indebted companies could struggle to make payments. Spreads versus safer investments may widen. That would make it more difficult for highly leveraged borrowers to meet obligations or refinance.
Right now, Moody’s assigns 29 per cent of leveraged loan issuers a B3 rating. Most CLOs promise to include only a limited amount of triple C-rated debt (the next rung down). If a recession leads to widespread downgrades, forced selling would flood the market.
And that could cause a big problem: the number of leveraged loan mutual funds and exchange traded funds has more than tripled since the global financial crisis. Mutual funds and ETFs allow immediate redemption, but the underlying loans trade relatively infrequently and sales take a long time to be settled. In a downturn, this could create a liquidity mismatch that banks may not be willing or able to bridge.
We got a hint of the risks last year. Between mid-November and January, investors pulled more than $16bn out of loan mutual funds and ETFs. The average price of leveraged loans fell about 3 per cent in December, the biggest one-month drop since August 2011.
Leveraged loans probably won’t spark the next recession, but they will almost certainly deepen it, because they are an important source of corporate funding for deals and share buybacks. That does not mean another banking crash is in the offing; most creditors are institutional investors rather than banks. The impact is more likely to be like the 2001 tech bust. But that was painful enough.
Just as Cape Cod’s shark sightings trigger official alarms, we have heard everyone from former Fed chair Janet Yellen to Moody’s and the Bank of England sound warnings about this market. When it exacerbates the next downturn, we can hardly act surprised.
The writer is global chief economist at Manulife Asset Management
No — They are resilient and stable, with fears about them based on fiction rather than fact
When sentiment diverges from reality, as it did in the leveraged loan market late last year, it can create great opportunities for long-term investors, writes Dwight Scott. However, some recent rhetoric about this important capital source has become so far removed from the evidence that it is important to lay out the facts.
Keep in mind this critical statistic. After the 2008 crisis, when the US economy suffered its worst downturn since the 1930s, the realised loss rate for collateralised loan obligations — portfolios of leveraged loans — was just above 1 per cent, compared with losses of nearly 40 per cent in the broader structured finance market.
The loans are so resilient because they sit at the top of the credit structure, secured by virtually all of the borrowing company’s assets. This provides substantial protection when a borrower runs into difficulty and has allowed leveraged loans to provide a positive return to investors in 18 of the last 20 years. Moreover leveraged loans are made at floating rates, typically repriced every 30 to 90 days: this is important in a dynamic rate environment.
The facts also do not back up assertions that the current leveraged loan market is creating meaningful risks to the financial system and broader economy. Let’s look at their claims of lower credit quality, rapid growth in issuance, and reduced investor protections, known as covenants.
Today, the issuers of leveraged loans are performing well and the overall levels of indebtedness of seasoned borrowers have continued to trend downward through 2018. This reflects solid underlying credit quality and a strong economic environment.
Revenue at the public companies included in the S&P/LSTA Leveraged Loan Index grew at double digit rates for the last four quarters, and ebitda growth reached a seven-year high of 13 per cent in the third quarter of 2018. While investors always must be cognisant of the risk of a future economic downturn, a majority of borrowers have recently refinanced, reducing interest costs and extending maturities, further strengthening their credit profile.
Companies on average have cash flow that is more than 4.5 times their interest payments, the highest ratio since at least 2001. Most borrowers do not have to refinance any time soon: only 4 per cent of outstanding loans are due to mature within the next two years.
Fears that a “liquidity mismatch” as occurred in 2008 will recur in the leveraged loan market are misplaced. Back then, subprime mortgages were held by deposit-funded banks or off-balance sheet vehicles backed by short-term liabilities. When investors fled, a squeeze developed. Now, a majority of leveraged loans are funded with long-term, locked up capital: CLOs, with stated maturities of 10 to 12 years. These are mostly held by institutional investors, providing more stable funding.
The US leveraged loan market has recorded a compound annual average growth from 2008 to 2018 of less than 4 per cent, far smaller than the 35 per cent annual growth rate experienced during the five years leading up to 2008. And the new issuance activity in recent years has been dominated by refinancing rather than new company debt.
The increase in “covenant lite” loans is not necessarily a sign of imprudent lending. Rather, it reflects the evolution of this market. Unlike banks, which often hold loans until repaid, today’s more diverse investor base actively buys and sells loans, making certain types of covenants less useful. If a loan’s risk profile changes, investors can sell.
The market still has robust underlying protections: during a downturn a secured loan is better positioned to protect investors than many similar credit investments. The most important factor in assessing credit risk is and has always been the underlying strength of the company and its capital structure.
None of this is to say that investors should be complacent about the potential risk. They have a fundamental responsibility rigorously to analyse companies, credit quality, and the structure of every loan agreement. But it is also vital to separate fact from fiction. And right now, the discussion over the leveraged loans has trended toward the latter, rather than the former.
The writer is president of GSO Capital Partners, Blackstone’s credit platform
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