On Wednesday afternoon, just after the closing bell sounded on the best day for U.S. stocks since 2009, I posted a funny chart in the live feed that showed the Invesco Senior Loan ETF scoring its best day since 2011.
What you see in the bottom pane below (i.e., the giant rally evidenced by the anomalous bright green bar) is probably something some folks are going to regret:
As regular readers (or really, anyone who consumes mainstream financial news) is no doubt aware, this product is on the frontlines of the leveraged loan blowup. BKLN has hemorrhaged cash over the past couple of months and wouldn’t you know it, Wednesday was no exception. Despite the rally, the vehicle lost another $6.6 million, marking the fifth consecutive day of outflows.
Meanwhile, the discount to NAV chart is extremely disconcerting (this is something we’ve mentioned before and it speaks to credit ETFs being stress-tested amid market jitters). Here’s the visual (top pane):
It’s also worth noting that the leveraged loan benchmark hit a fresh 29-month low on Wednesday, perhaps underscoring the contention that fleeting risk rallies aren’t going to be enough to shore up sentiment in the space.
Frankly, this could be a pointless post. I’m not sure there’s much to be gleaned during the last week of the year, but given all the attention the leveraged loan story has received over the past three months, I’m pretty confident the above at least bears mentioning.
Meanwhile, Goldman was out with a note on the market a couple of weeks back that I assume was quoted by someone, somewhere, but just in case, it’s worth highlighting a couple of passages for readers in light of recent events.
Previously, we mentioned that although leveraged loans have ballooned to a $1.1 trillion market, the bursting of this bubble isn’t generally seen as a systemic risk by analysts, even if it’s a hot topic among regulators, “brand name” economists and other pundits. What’s perhaps more pernicious than the market itself is the prospect that an unwind could start tipping dominos on the way to creating a kind of self-fulfilling prophecy.
“Over-indebted corporations may be unable to repay their loans if interest rates rise meaningfully or earnings decline significantly [and] lenders may [then] cut back lending in response to a rise in defaults, which in turn would likely weigh on investment and activity”, Goldman writes, in the note mentioned above, before closing the loop by way of cautioning that “a potential mismatch between the short-term funding of lenders and the longer-term assets could create, in principle, conditions that can lead to runs on the short-term liabilities of banks.”
That isn’t really the bank’s “base case”, but that’s the hypothetical “bad” scenario. Goldman also reminds everyone that the total outstanding here is roughly 5.5% of GDP while the CLO market is about half that.
Obviously, underwriting standards have loosened materially as demand for floating-rate products increased amid voracious investor appetite and demand from the CLO machine. There are number of ways that’s manifesting itself and everyone is familiar with the proliferation of cov-lite deals. Here’s Goldman with some further color which, again, will be old news to those well-versed in the story, but might be of use to other readers.
Leveraged loans are a risky product and default rates tend to spike in recessions, with a rise above 7% in 2001 and above 10% in 2009. Moreover, underwriting standards on leveraged loans have loosened in the last few years. The share of highly levered deals has risen and “EBITDA add backs” (which could overstate the ability to repay) and “incremental facilities” (which allow additional borrowing with equal seniority with the existing bank loans) are increasingly used.
Whether or not the chickens finally come home to roost in the form of a surge in defaults is largely down to whether earnings hold up and a recession is averted. Amusingly, Goldman also contends that this time around, investors might actually understand what it is they’re buying. “Our credit strategists emphasize that the significant growth of cov-lite loans overstates the easing in credit standards, as it largely reflects a structural shift towards a more ‘bond-like’ market where lenders typically understand the risk they are taking”, the bank says.
In any event, if you’re looking for the silver lining in this story, the good news would appear to be that banks aren’t nearly as exposed. “Banks’ allocations to new leveraged loan deals in the primary have fallen from 30% twenty years ago to less than 5%, as the share of institutional investors has risen rapidly to about 90%”, Goldman adds, in the final section of their latest loan missive.
You can make of all this what you will, but the bottom line is that this story isn’t going away anytime soon.
The more evidence there is to support the recession narrative, the more pressure the market is likely to see, given the read-through for defaults and also for demand for floating-rate securities in an environment where the Fed opts for a hard “stop”.