Look, I don’t want to trivialize the bubble (and likely unwind) in the leveraged loan market, but this is another one of those stories where I’m a bit incredulous at the way it’s being covered and otherwise discussed.
Suddenly, some of the biggest names in the financial universe (both individual people and entities) are screaming from the rooftops about this market as though it’s just now occurred to everybody that it’s a potential problem. On top of that, people are analyzing the situation as if there’s something mysterious about how we got to where we are.
This is a ~$1.1 trillion market and the appetite for these deals has grown in an environment where folks are after floating-rate debt as the Fed hikes rates. Obviously, the more demand there is for these deals (e.g., from CLOs), the more competition they’ll be to get them done. The more competition there is, the looser the standards, hence the disconcertingly high percentage of cov-lite deals (something like 80% of outstanding loans as of the end of August). As you’ve probably heard, CLOs have been on fire and the securitization machine got an extra boost from the repeal of risk-retention rules (a development celebrated by many).
It’s worth noting that it might not be entirely fair to put the blame on securitization when it comes to leveraged loan bubble. “It should be noted that the US CLO market as a percentage of the leveraged loan market has actually remained relatively steady through the years, debunking the myth that it is the CLO machine that has been fueling the growth of the leveraged loan market over the last decade”, BofAML wrote in a note dated November 20.
Long story short, a lot can go wrong here (especially now that we’re near the end of the cycle) and the larger the market is, the greater the chances that when something finally does go wrong, it becomes systemic.
That’s pretty much all there is to this although I’m sure someone will claim I’m oversimplifying it.
Predictably, the market is looking like it wants to roll over in the face of growing concerns about credit more generally and presumably due to oversupply and also to the prospect that the Fed could put the brakes on rate hikes, a development which could dent demand for floating-rate assets.
So far this year, leveraged loans have been an oasis for investors in an environment where the vast majority of assets have struggled to perform. Here, for instance, is a simple chart that shows how the space has logged a ~3.5% return versus losses across investment grade, high yield and equities.
Amid the recent turmoil in credit markets, the benchmark for leveraged loans dove to a two-year low this month.
Well, the first high profile casualty looks like it’s going to be the Invesco Senior Loan ETF and by “casualty”, I just mean it’s recent trials and tribulation made headlines late this week across the financial media and also on a couple of blogs.
Basically, it’s hemorrhaging. The fund has seen outflows for eight consecutive sessions amid a plunge in the shares to their lowest in 31 months. This looks truly unfortunate when you chart it.
Volume exploded this week. The fund traded nearly 30 million shares on Tuesday.
Finally, see the chart below which is a rather poignant visualization that captures the shares diving to their lowest since April 2016 on top of a histogram which is just the ratio of turnover to traded value (obviously, you’re looking the dramatic decline in the pink line concurrent with the spike in the blue bars over there on the right-hand side).
So, yeah – there’s trouble in paradise where “paradise” means one of the handful of assets that’s actually managed to post a positive return in an otherwise miserable year across markets. This is playing out alongside the tumult in high yield and amid the broader selloff in risk assets.
Read more on high yield’s recent travails
If you’re wondering whether this has the potential to become dangerous in the event managers run out of higher quality paper to sell (to meet outflows) and end up having to dump lesser quality assets into a falling market where liquidity is thin, the answer is obviously “yes”, although just to reiterate what I said here at the outset, I’m not sure that’s some kind of revelation as much as it is just a generic description of a fire sale.
As far as CLOs go, BofAML expects a slow grind higher in defaults, but nothing too catastrophic. “Overall benign fundamentals have helped keep default rates below historical averages through 2018, and we expect them to still remain so in 2019”, the bank writes, in their year-ahead CLO outlook (the same piece cited above).
“According to a recent survey conducted by LCD, asset managers expect the 12-month rate to conclude 2019 at about 2.54% by dollar amount [and] the official forecast our loan strategists put out is also 2.5% by 19YE”, the bank continues, adding that “given this backdrop, we see room for the overall loan asset class to continue with its outperformance heading into 2019, especially early in the year.”
For whatever this is worth, Goldman reminds you that “the percentage of leveraged loan issuers with weak interest coverage ratios (below 1.5x) is still hovering near the record low of 3.5% reached in 1Q2018 [and] barring an unexpected negative shock to earnings, current coverage ratios provide companies with a solid cushion against late-cycle pressure.”
In any event, you can make of all this what you will. I’m not going to close with some kind of particularly dire prediction because, frankly, the time to worry about this was at least a year ago. Now it just is what it is and whatever happens happens. Best of luck with it.