December revealed the serious threat leveraged loans pose to the financial system.
Why are investors still not listening?
The following article was originally published in “What I Learned This Week” on January 31, 2019. To learn more about 13D’s investment research, please visit our website.
In recent months, the warnings have come one after another. They’ve come from institutions: the IMF, Moody’s, S&P Global, the Bank for International Settlements, the Fed, the Bank of England (BoE), and the Reserve Bank of Australia. They’ve come from market leaders: JP Morgan’s Jamie Dimon, Baupost’s Seth Klarman, Barclay’s Jes Staley, and KKR’s Henry McVey, to name just a few. In October, former Fed chair Janet Yellen summed up the concern about leveraged loans shared by so many: “If we have a downturn in the economy, there are a lot of firms that will go bankrupt…because of this debt.”
Time and again in these pages, we have warned about the dangerous divergence between corporate debt levels and default rates driven by the lowest interest rates in history (see WILTWs March 22, and September 27, 2018). December gave us a glimpse of how costly this could prove. Fed hawkishness — combined with the warnings of market luminaries — spooked leveraged loan investors, causing loan prices to slide more than 3%, the most since August 2011 when the U.S. government was downgraded and lost its triple-A rating.
Yet, the episode sent a bigger message than just the investor pain: a liquidity shock may be inevitable and the market is not prepared. As Guggenheim’s CIO Scott Minerd told Bloomberg at Davos: “What was really amazing to me was how crowded and congested the exits got when people starting moving in that direction…You wanted to adjust the risk based upon the volatility…you couldn’t get good prices.”
Despite the plethora of warnings from market luminaries, January has seen a rebound in the leveraged loan market with the S&P loan index seeing its biggest six-day advance since 2009 and recovering most of its December losses. Many have taken comfort in the idea that the sell-off cleared out weak hands, gave buyers the power to strengthen covenants, and forced a more dovish stance from the Fed.
However, optimism today neglects the threats built up over years. There are too many over-levered, weak companies and too many investors unaware that they’ll be left holding the bag when a recession ushers in a reckoning. The consequences of leveraged loan excesses may not be as severe as subprime excesses were last decade, but the same recipe for panic exists.
Because there is no roundly-accepted definition of what qualifies as a leveraged loan, the total volume of leveraged loans outstanding globally is up for debate. The most commonly cited figure is $1.3 trillion. The BoE estimates the figure is much higher — $2.2 trillion (chart below). “This makes the stock of leveraged loans in 2018 comparable to the stock of U.S. subprime mortgages before the onset of the financial crisis,” the central bank said in a report released this week.
Regardless of the debate over the scale of the problem, the astronomical growth of leveraged loans is clear. In the early 2000s, leveraged loans accounted for “only about 2% of all [U.S.] corporate debt,” according to The Wall Street Journal. Today, that number exceeds 11%. The value of outstanding CLOs — which buy leveraged loans from banks and then package them into tiered tranches — has more than doubled since 2007, exceeding $600 billion by the end of 2018.
And as the market has grown, the quality of the loans has rapidly deteriorated. According to The Financial Times: “For a third of all loans issued in 2018, leverage levels crept above six times…exceeding guidance put out by the Office of the Comptroller of the Currency in 2013.” Covenant-lite loans — loans where financial maintenance protections have been removed — now account for 80% of leveraged loans outstanding, up from 55% in 2014. As a result, Moody’s estimates that “recoveries on so-called ‘first-lien’ loans — which rank first in a debt workout — would likely fall from the historical average of 77 cents on the dollar to 61 cents…The recoveries on riskier ‘second-lien’ loans will tumble from 43 cents to just 14 cents.”
Compounding the threat is the changing makeup of the investor base. Through loan mutual funds and ETFs, retail investors have gained unprecedented access to the leveraged loan market:
The explosion in leveraged loans has been predicated on two common assumptions. First, they fared well during the financial crisis, therefore, they’re resilient. Second, they’re transparent — covenant changes are spelled out in legal documents — therefore investors know what they hold. The former neglects the unprecedented growth and quality-deterioration of the market. And the latter neglects the fact that the spike in retail participation likely means a spike in misunderstandings about risk.
Recent months have provided plenty of examples of why ill-informed investors could be caught flat-footed. Today, roughly a third of loan collateral is intangible assets. It’s much easier to restructure those assets so they’re out of reach of creditors — at least when covenants don’t forbid it. As Bloomberg reported earlier this month:
“One of the first signs of the potential trouble ahead for loan investors came from J. Crew Group. In 2016, the preppy clothing retailer told lenders it was moving intellectual property including its brand name into a new unit that was out of the reach of creditors as part of a restructuring, a process it completed in July 2018. Litigation ensued, as angry lenders said that collateral was being taken away from them…J. Crew’s efforts seem to have inspired other private-equity-owned retailers as well. PetSmart Inc. and Neiman Marcus Group Inc., for example, have shuffled online businesses into different units where lenders can’t reach them…‘Collateral is a big long-term risk,’ said Chris Mawn, head of the corporate loan business at investment manager CarVal Investors. ‘You think you’re secured by a Cadillac, but three years from now, it turns out you’ve got a Chevy.’”
So what could trigger a crisis? As we’ve cited in these pages previously, 14% of firms in the S&P 1500 are zombies, meaning they do not have enough earnings before interest and taxes to cover interest expenses. The corporate bankruptcy rate has been historically low for historically long. Interest rates have risen. As S&P Global wrote in a report last year, “Something’s gotta give.”
United States Bankruptcies
Yet, downgrades may be the more likely and significant threat in the event of a recession. Moody’s currently rates roughly 29% of leveraged-loan issuers at B3, which compares to just 14% a decade ago. Many CLOs only allow a certain allocation to triple-C obligations. Meaning, if a recession degrades corporate profitability and Moody’s is forced to downgrade loans to junk, CLOs could flood the market with supply. And a flood of supply could trigger the loan ETF “death spiral” we described in WILTW December 6, 2018. This threat was evident in December. As Guggenheim’s Minerd told Bloomberg:
“On a good day, you can make [a leveraged loan sale] in two weeks. Typically, something delays it, so it can take three, maybe four weeks to clear a loan. That’s a real challenge when you get into these more liquid products like ETFs because the ETFs provide you next-day liquidity so if you’re trying to liquidate loans in an ETF to get out — and we did see it in the sell-off — you can start to see gaps of NAV below.”
According to Jamie Dimon, the major banks are not nearly as vulnerable to a leverage blow-up today as they were a decade ago — the industry’s exposure in leveraged-lending bridge books is at $80 billion, or roughly one-fifth of what was held in 2007. It’s possible that concern today could trigger the restraint necessary to mitigate damage tomorrow. However, given the renewed enthusiasm for leveraged loans seen in January, it appears far more likely loan quality will continue to deteriorate until a recession forces a reckoning. KKR’s move to “neutral” from “overweight” earlier this month sent a clear message: now is the time to reduce exposure to the leveraged loan threat.
This article was originally published in “What I Learned This Week” on January 31, 2018. To subscribe to our weekly newsletter, visit 13D.com or find us on Twitter @WhatILearnedTW.
