Clock Strikes Midnight On Leveraged Loan Cinderella Story As Outflows Hit New Record

Broken records, anybody?

If it feels like you’re reading this news for the fifth consecutive week, that’s because you are – basically.

Leveraged loan funds continued to hemorrhage in the week through Wednesday, the latest Lipper data shows. Specifically, investors yanked another $3.3 billion from mutual funds and ETFs, marking the fifth consecutive week of outflows.

This is hardly surprising. These flows trail the secondary market and the fundamental backdrop continues to deteriorate. The benchmark index is in free fall for all intents and purposes. Have a look at this:

(Bloomberg) 

Here’s the price index with YTD total returns:

(Bloomberg)

The story is the same as it’s been for months. Leveraged loans were one of the only assets that performed for investors in an otherwise abysmal year, but demand for the debt soured amid concerns about risky credit and as the appeal of floating-rate products diminished thanks to expectations of a more dovish Fed path. While Wednesday’s Fed decision suggested Jerome Powell is intent on squeezing in some additional tightening, the dots shifted lower and if you ask the market, even the lower projected path isn’t likely to be realized. Throw in broader concerns about the U.S. economy and sentiment is suddenly in the gutter.

And so, deals are being pulled, investors are demanding stricter protections and seasonality is weighing. The combination of these factors has eroded YTD returns and closed the performance gap with IG (although high yield’s recent trials and tribulations mean loans still look pretty good on the year by comparison).

(Bloomberg)

As worries mount over the timing of the next downturn, appetite for loans is likely to wane further, although Wall Street is generally divided over the prospects for the space in 2019.

For the uninitiated, it’s worth quoting the following passage from Wells Fargo, who, in a note dated December 18, assesses the implications of a leveraged loan blowup for the broader economy.

The leveraged loan market in the United States has mushroomed to more than $1 trillion today from only $5 billion about 20 years ago. Growth has been especially marked in the past two years with the amount of leveraged loans outstanding up more than 30% since late 2016.

And here’s Wells on what the recent stumble means from a 30,000 foot perspective:

In our view, the leveraged loan market, taken in isolation, is not likely to bring the economy to its knees anytime soon. But its recent weakness may reflect a broader economic reality. Namely, the overall financial health of the non-financial corporate sector has deteriorated modestly over the past few years. If the Fed continues to push up interest rates and if corporate debt continues to rise, then financial conditions would tighten further, which could eventually lead to a sharper slowdown, if not an outright downturn, in economic growth.

Obviously, the fate of the CLO machine hangs in the balance here. 2018 was a banner year, with sales hitting a record $125 billion (ex-reissues). That’s a fee-generation machine for the folks who structure the products and, again, it’s possible the party is over.

Whatever the case, the bottom line continues to be that the clock struck midnight on this Cinderella story in November and given that the percentage of these things trading above par has plunged of late, it’s probably safe to say: “It’s in the hole!”…