Leveraged Loan Safety Net May Prove Frayed for Investors

(Bloomberg) -- It was enough to set investors’ teeth on edge.

When KKR & Co. tried to sell money managers pieces of a $1 billion loan to fund its buyout of Heartland Dental, it included a bold ask: it wanted credit now for earnings the company expected to get in the future from offices it had just opened. That helped nearly double a measure of income that will be used to test whether the dental-office services company is making enough money to keep borrowing, according to people with knowledge of the matter.

Heartland Dental got what it wanted in the end and sold its loans late last month. Its success underscores how money managers can’t get enough loans to junk-rated companies now, and how that strong demand is allowing borrowers in the $1 trillion market for leveraged loans to push the envelope and make the debt riskier.

It’s a surprising outcome because the money managers that are piling into loans are seeking investments that offer safety compared with junk bonds. Loans are usually first to be repaid when a company goes under, so they tend to perform better in a downturn than bonds, which are often second or third. As the loan trade becomes more crowded, the peace of mind that investors are looking for may prove illusory, said Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC. Eventual losses could be high by historic standards.

“The selling points made to buyers are remarkably similar to those made to buyers of subprime mortgages,” LeBas said referring to the securities that helped bring trillions of dollars of losses to investors during the 2008 financial crisis. “Low default rates justify weaker documentation and covenant structures deteriorating, and there’s not a lot of pushback against it. Those are yellow flags.”

Read about leveraged loans, risks in European high-yield debt and distressed companies.

When the credit cycle does turn, investors used to recovering around 77 cents on the dollar from first-lien loans to failed companies may find themselves with closer to 60 cents, Moody’s Investors Service forecast in March. For second-lien loans, 43 percent historical recoveries may fall to 14 percent, Moody’s said.

Growth, Risk

The market for loans to highly indebted companies has grown almost 50 percent since 2013, making it almost as big as the U.S. junk bond market. There have been 11 straight weeks of inflows to U.S. leveraged loan funds, according to data from Lipper.

That growth has allowed corporations to take on more debt. The average company in a leveraged buyout had borrowings equal to 6.4 times a measure of income known as earnings before interest, tax, depreciation, and amortization in 2018, according to Fitch Ratings. Last year it was 6.2 times and in 2016, it was 5.9 times.

Amid that growth, investors have become more willing to accept weaker protections known as covenants. One such safeguard measures how easily a company can afford to pay interest by comparing its Ebitda to its interest expense. When that ratio gets too low, lenders can demand repayment.

Companies have been getting more aggressive in monkeying with how Ebitda is calculated, often by adding future revenue or subtracting current expenses. While such add-backs have long been done to factor out one-time events that might distort a metric of a company’s health, over time the adjustments have grown more aggressive.

“Battle lines are being drawn between the aggressive versus the reasonable in both add-backs and covenants,” said Christopher Remington, an institutional portfolio manager at Eaton Vance. “We are increasingly digging in on covenant issues.”

With Heartland Dental, the company’s add-backs included assumptions that new business would be as profitable as longer-term clients, and that opening and closing offices would incur no expense, the people said. While the company has included these add-backs in its lending agreements since 2012, the adjustments had never had such a big impact on Ebitda.

Representatives for Heartland Dental, KKR and Jefferies Group, which led the financing, declined to comment.

Lax Covenants

Other safeguards for borrowers have been getting weaker too. A higher percentage of loans are "cov lite," meaning they have the more lax covenants typically seen on high-yield debt instead of the more stringent ones that were historically baked into leveraged loans. Covenant-lite loans comprised almost 80 percent of the U.S. market in 2017, a record and up from 75 percent in 2016, according to Moody’s.

And while loan lenders are first to be repaid if a company goes under, a growing percentage of borrowers have loans as their only form of debt, which can force these creditors to take more losses.

Investors that do look to shed their holdings will find it takes on average 17 days to settle a loan trade, according to IHS Markit, compared to three days for a bond. That slowness could strain loan mutual funds and exchange-traded funds, which promise their own investors that they can sell out of the fund on short order. These funds hold about 15 percent of leveraged loans.

There are still reasons for investors to be sanguine about the loans. The economy is growing at a solid pace, and unemployment in April fell to its lowest level since 2000. The biggest buyers of loans, known as collateralized loan obligations, tend to hold their loans long-term, so any turn in the economic cycle may not impact them much if they wait it out.

“The most important thing is that fundamentals and the broader market are very much in check. Companies are on a solid footing and the economic backdrop is good,” Eaton Vance’s Remington said.

But at some point, companies and the broader economy will face strain. More companies might feel that pain as the Federal Reserve readies to increase rates at two or three more times this year.

“It all works until rates get too high,” said Ethan Lai, an associate portfolio manager at Leader Capital Corp. “Then that wall hits.”

©2018 Bloomberg L.P.

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