Leveraged Loans Are Flying Off the Shelves
(Bloomberg) -- Money managers, eager for assets whose yields rise as the Federal Reserve hikes rates, snatched up some of the year’s biggest leveraged loan offerings this week. Some caution that investors may be buying at the wrong time.
Usually after the Fed tightens the money supply, economic growth slows, which results in more defaults on corporate debt and lower returns for the whole loan market, said Gershon Distenfeld, co-head of fixed income at AllianceBernstein LP.
A good proxy for the potential risk is to look at returns when loan prices rise too high, Distenfeld said. When the average outstanding loan is around current levels of 98.5 cents on the dollar or above, annual returns are about 2.8 percent for the next two years, trailing five-year Treasuries and high-yield bonds, according to his analysis of market prices between January 1992 and May 2018. Distenfeld has long been skeptical of bank loans.
Sub-par returns are bad enough, but this time loans could perform worse than they usually do, said Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC. Lender protections are worse than usual, and there are fewer other creditors to absorb losses.
“It’s not a good time to be buying bank loans,” LeBas said.
Whether or not that’s so, a lot of money managers are buying them. Blackstone Group LP this week borrowed $9.25 billion in the U.S. and European loan market to fund its buyout of a stake in Thomson Reuters Corp.’s financial terminal business, and received orders far in excess of supply, in one of the biggest leveraged loan financings of the year. Carlyle Group LP cut rates twice on $6.4 billion of U.S. and European loans for its acquisition of AkzoNobel Specialty Chemicals amid strong demand. New U.S. leveraged loans are on track for a record-setting year, according to data compiled by Bloomberg, and the U.S. market tops $1 trillion outstanding.
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Retail investors have poured cash into funds that buy loans, with $282 million of inflows into mutual funds and exchange traded funds in the week ended Sept. 12, the 10th straight week of money coming in, according to Lipper data. Pension funds have also been big buyers of credit products broadly, according to a report by Canaccord Genuity. And some $84 billion of collateralized loan obligations have been sold this year, a record pace, which fuel demand for loans by buying them and repackaging them into securities.
So far this year, buying loans has been a great trade. Leveraged loans have gained 3.8 percent this year including price movements and interest, according to the S&P/LSTA Leveraged Loan index, compared with a loss of 2.6 percent for investment-grade U.S. corporate debt and a 2.4 percent gain for junk bonds, according to Bloomberg Barclays index data.
Investors are looking to buy instruments that pay floating rates, meaning their prices don’t fall as the Fed tightens monetary policy. The U.S. central bank is widely expected to hike rates when it meets next week, and futures markets also project increases in December and at least one more time next year. Loans are also attractive because they are first to be repaid if a company goes under, making them less risky than corporate bonds that are usually behind loans in the pecking order.
There are reasons to be sanguine about the market. Goldman Sachs Group’s Amanda Lynam wrote in a report this week that money managers are pushing back on deals that are too aggressively priced, profits are improving at many companies, and borrowers have cut debt levels, meaning the market isn’t overheating.
“The risks in the leveraged loan market, broadly, are manageable and not close to an inflection point,” Lynam wrote.
Even if an inflection point is far away, the risks are building up. Moody’s Investors Service in August highlighted how borrowers are eliminating investor protections on loans known as covenants. That could lead to lower recoveries in the next downturn, the ratings company said, predicting average U.S. first-lien term loan recoveries would fall to 61 percent, versus their 77 percent long-term historical average. For the second lien, recoveries could be 14 percent, compared with a 43 percent historical average.
In addition to weaker covenants, companies have taken on a lot more loan debt during this cycle, than they’ve had historically, and have comparatively fewer bonds. Those factors mean recoveries for first-lien loans could be closer to 50 cents on the dollar, said Tom Mansley, investment director at GAM Investments.
“There’s a tremendous supply in the marketplace and at the same time, we’ve definitely seen deteriorating fundamentals,” Mansley said. “That’s going to lead to low recovery rates going forward.”
Supply may not be strong for much longer, said Neil Desai, portfolio manager at Highland Capital Management. CLOs seem to be getting created faster than the loans needed to feed them at this stage, which eventually hurts the economics of putting together CLOs.
“We envision there being an inflection point where the decreased loan issuance pipeline could start to slow down the CLO machine,” perhaps as soon as year-end, Desai said.
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