Admittedly, this has not been a week defined by reader interest in deep finance or really, in “shallow” finance either.
Maybe it’s the fact that this was a holiday-shortened week in the US. Or maybe it’s the fact that markets are exhibiting a kind of “frozen in time” feel pending a resolution to the trade conflict, the release of the Mueller report and/or a decisive turn for the worse (or better) in the data that would either confirm or disprove the “imminent global downturn” narrative. Or perhaps the dovish pivot from monetary policymakers has left folks content to assume that things will be fine barring some kind of left-field tail event that makes panic “great again”.
But whatever it is, it feels like everyone is fine with indulging in cheap news thrills tied to things like Bob Kraft’s alleged affinity for Florida prostitutes and Warren Buffett’s Friday paper losses (somewhere in the neighborhood of $3 billion) for the time being.
Given that, we’re going to go ahead and “waste” time on something nobody cares about this week: leveraged loans.
And you know, it’s funny, because back in November and December, when the financial universe was imploding, stories about the bursting of the leveraged loan bubble were so popular that you might well have garnered more clicks writing about BKLN flows than you would have documenting Bob Kraft getting a handjob and “bursting” at the “Orchids of Asia” day spa.
Relive the drama
The narrative was straightforward. Leveraged loans were one of the only assets that performed for investors in an otherwise abysmal year, but starting in Q4, 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. Ultimately, outflows accelerated, prices fell and people freaked out.
The fact that the market was the subject of cat calls from a variety of high profile names prior to the mini-meltdown only added to the sense of panic. Throw in broader concerns about the US economy (not to mention a dash of seasonality) and the market ultimately succumbed to the same collapse in confidence that gripped risk assets more generally.
The market rebounded in 2019, but that’s since stalled a bit, which brings us quickly to this week and a new article from Bloomberg that cites Prequin data showing PE firms are sitting on some $1.2 trillion in dry powder.
“That’s how much money private equity firms globally had available to deploy as of the end of last year, a record level that’s 17% above 2017 figures”, Lisa Lee writes, before contending that “the buyouts they’ll need to finance should keep [leveraged loan and junk bond] issuance volume from plunging this year.”
Obviously, less supply is a bullish technical, so getting a read on the likely trend in issuance is key for investors. Assuming the cycle isn’t turning and volatility remains suppressed, M&A-related activity should remain some semblance of robust, despite the tax cuts having reduced financing needs and despite ongoing trade jitters potentially making dealmakers more cautious.
Additionally, the linked Bloomberg piece notes that “more borrowers are getting loans in the private markets, instead of syndicated loans”. That’s an important point and goes to the heart of worries about the growth of the private debt market, something we’ve written voluminously about in these pages.
But you don’t care about any of that, do you? No, you don’t. Because you’re a crowd of people who want to hear about potential land mines and who like to indulge in horror stories about systemic risk.
Well, when it comes to doomsday predictions and leveraged loans, nothing gets the blood flowing quite like the cov-lite discussion.
Uncritical “analysis” invariably cites the same statistic – namely that 80% of loans outstanding are now covenant-lite.
If you’re into financial doomsday propaganda, that’s really the only statistic you need. Armed with that chart, a handful of quotables about the growth of the loan market and a modicum of creative writing skills, you can churn out a theoretically endless number of foreboding posts that will get shared all over finance Twitter assuming that crowd isn’t too busy reading about Bob Kraft and his “Orchids of Asia”.
But there’s more than a little nuance here, and we’ve tried our best to communicate that on any number of occasions over the past several months. Thankfully, Barclays is out with a sweeping new note that helps to shed to some light (or, “lite”, if you’re into bad jokes) on what’s really going on.
For one thing, the bank notes that cov-lite doesn’t mean “no covenants”, something which may come as a surprise to those of you who are inclined to read only the scariest-sounding stories about this market. Here’s Barclays to ‘splain:
Broadly, cov-lite loans have bond-like incurrence covenants, while covenant-heavy loans have maintenance tests. The latter require the issuer to meet financial requirements (such as leverage and/or coverage levels) at periodic intervals, often at quarterly or semi-annual earnings releases. They are always enforceable and not ‘springing’ under certain scenarios. Conversely, for cov-lite loans’ incurrence covenants, financial restrictions are enforceable only in certain scenarios such as additional debt issuance, dividend payments, share repurchases, mergers, acquisitions, or asset sales.
So, this is basically just turning into the bond market, which doesn’t sound nearly as scary. Barclays reiterates that point, noting that if you think about this as a scenario where issuers are turning to cov-lite loans rather than bonds, that transition “does not represent an aggregate decline in covenant protection.”
That said, nobody is under the impression that this isn’t what it is, so to speak. The bank goes on to say that as the loan market grows, protections have obviously weakened – and across the board at that.
“Currently, 94% of cov-heavy first-lien loans have two or fewer covenants, a significant change from pre-crisis levels, when three or more covenants were common”, Barclays points out, on the way to observing that “the average number of covenants stands at just 1.3, the lowest level in history.”
One of the critical points when it comes to explaining these trends is the epochal shift in the investor base. In the past, small bank groups comprised a large share of the buyer base whereas now, ownership is more multifarious. That contributes to the shift towards cov-lite deals, as the more widely held the market is, the less feasible it is to enforce maintenance covenants.
“The loan market buyer base, which was previously dominated by small bank groups that could easily come together to discuss amendments for borrowers, has become much broader in recent years”, Barclays notes, adding that “from an operational perspective, this change in ownership is likely contributing to the decline in covenants.”
As an interesting aside, Bloomberg’s Kelsey Butler pointed out on Friday morning that as issuance has slowed, “the market has seen an uptick in deals embedded with maintenance covenants.” Specifically, Butler notes that “at least three deals circulating this week included financial tests of some sort [while] only one covenant-lite loan came to market [making this] the lightest week for covenant-lite issuance since the abbreviated one at the start of the year, and the slowest full week since mid-2016.”
Getting back to Barclays, the bank does concede the obvious, which is that changes in the buyer base aren’t the only factor at play. The following passage is highly useful and remarkably effective at driving home a number of key points in just a few words, so we’ll excerpt it in full. To wit:
But the demand changes are more than just operational – they have been excessive relative to the supply of loans, driven by both CLOs and retail investors. CLOs now own 60% of the loan market. That percentage has been growing in recent years as CLO creation has outstripped even the strong growth of the loan market. In addition, retail loan funds have grown from $60bn to $125bn from the end of 2011 to now. As a result of this loan dedicated demand, investors needed the market to grow, and issuers were able to threaten to take their business to the always “cov-lite” bond market instead if they were forced to face more stringent terms in the loan market. Demand was not comparable in the bond market, but since that market has been shrinking modestly since 2015, investors likely would have been happy to look at new issue. Investors were therefore faced with few alternatives, and the answer was a wholesale shift to cov-lite.
If you’ve followed along with all of this (and if you’ve kept yourself apprised of this story more generally), you can probably anticipate why Barclays comes away thinking that the growth of the market and the proliferation of cov-lite loans doesn’t pose a systemic risk.
First, if you conceptualize this as a broad “bond-to-loan” shift, it’s actually possible to think about it as a positive development. “Cov-lite loans that would, in other environments, have been issued in bond form, do not represent an actual loss of protection”, Barclays writes, adding that in fact, “they may represent an increase in protection, since they likely come with as many or more covenants than bonds, as well as increased security.”
Second, the fact that less of this exposure is concentrated with banks is almost unequivocally a positive development when it comes to assessing systemic risk. The chances of fire sales are presumably much lower and the odds of a domino effect taking hold are dramatically reduced.
So there’s a cov-lite “reality check” for you that will hopefully serve as a counterpoint to some of the doomsday calls (as an added bonus, this post will be a great source of self-deprecating humor if this “bubble” does finally burst on the way to bringing about a horrible recession).
Meanwhile, bank loan funds continue to see outflows. As Goldman wrote earlier this week, some $4 billion has come out so far in 2019 and that’s on top of the massive $15.5 billion that fled screaming in Q4 amid the selloff.
“Loan funds have lost 16.5% of their assets under management since early October”, Goldman flatly states, in the course of lamenting the extent to which “the negative press from various central bank officials in recent months – which has emphasized the potential for overheating risks in the leveraged loan market and even drew parallels to the 2008 subprime mortgage crisis – has weighed heavily on investor sentiment, contributing to the outflows.”
For what it’s worth, Goldman still recommends leveraged loans over high yield bonds in 2019.
And with that, I’m done.