In Q4 of 2018, there was no shortage of dire-sounding commentary around leveraged loans.
The warnings emanated from all corners of the financial universe including a veritable laundry list of “name brand” entities and individuals, who pretty much universally insisted that the market was a screeching tea kettle just waiting to explode
By late December, the benchmark had plunged, the Invesco Senior Loan ETF (the retail product on the frontlines of what, at the time, was a burgeoning blowup) was hemorrhaging cash and many market participants came to believe the clock struck midnight on the leveraged loan Cinderella story sometime in November.
Relive the drama
The apocalypse never really panned out, but recently, cracks have started to form anew, prompting the usual questions from skeptical market participants.
“The possibility of continued rate cuts by the Fed has made floating-rate deals less attractive, and companies vulnerable to trade wars have had to promise higher yields”, Bloomberg wrote in August. “CLOs are the biggest holders of loans to junk-rated companies [and] concerns are mounting about how the structures owning so much of corporate America’s debt will react if a recession hits”, a separate article from earlier this month reads.
Again, those are familiar concerns. Worries about floating-rate products losing their luster in a falling rates environment and jitters over the CLO machine were front and center starting in November of 2018 (and really, before then).
Well, for what it’s worth, Goldman is out striking a decidedly cautious tone on the market, in contrast to the more upbeat view they expressed last year.
“At year ago, we acknowledged the new issue market’s excessive issuer-friendliness but we took comfort from the meaningful improvement in credit metrics at the overall index level as evidenced by increasing coverage ratios and declining net leverage”, the bank writes, in a note dated October 29. “We also expected investor discipline would eventually return to the market given the emerging signs of weaker demand technicals”.
12 months makes a big difference, apparently. “A year later, the picture has turned more mixed, as the persistent issuer-friendliness of the primary market flow channel has now negatively affected the broader universe of leveraged loan issuers”, Goldman warns, adding that they’re also worried about “the significant uptick in the pace of downgrades in the low end of the rating spectrum”, which the bank notes is “a sharp contrast with the high yield bond market”.
Meanwhile, net issuance has collapsed, which, under normal circumstances would make for a bullish technical, but the demand side of the equation is rough, and that has direct implications for the CLO machine.
“The large and persistent outflows from bank loan mutual funds and ETFs that depleted 35% of total AUM since mid-October 2018, have rendered the leveraged loan market almost entirely dependent on the CLO bid”, Goldman writes.
At this point, CLOs account for nearly three-quarters of the new issue market. That’s a record.
(Goldman)
Obviously, that leaves the market vulnerable in an environment where CLO creation is decelerating at a near 10% clip. Goldman also flags high ownership concentration of the global CLO market in Japanese banks (around 15%). If quality trends continue to deteriorate, those institutions aren’t likely to increase their exposure any further.
At the same time, the trend in negative rating migration may handcuff CLOs. As Bloomberg wrote in the first linked piece above, “downgrades can trigger selling by money managers… includ[ing] collateralized loan obligations [as] most CLOs can’t hold more than 7.5% of their portfolios in loans rated CCC”.
If you ask Goldman, it still doesn’t make much sense to suggest that a bursting of the leveraged loan “bubble” would somehow spark a crisis on par with the implosion of the subprime market during the GFC. But the bank does caution that the fundamental backdrop has become considerably weaker and that the supply/demand picture is, to put it nicely, “fragile”.
