Depending on the source, views on the state of the leveraged loan market range from euphoria to growing pessimism. Among the former is Brian Reynolds, Chief Market Strategist who in his Oct 24 Market Insight note writes the following:
The September credit issuance surge resulted in the loan market being overserved with low quality deals. So, loan yields have come up a little, and loan prices have come down a little. Every time this has happened in this decade-long credit cycle, it has been a buying opportunity, even though some equity investors are worried about this price drop. Since loan yields are up, Liberty Cable reduced the size of their loan by $200 million and increased the size of their bond by the same amount.
Lenders still threw money at the company, giving them a $1 billion term loan for 7 years at a spread of only 500 basis points over Libor. If there was really a problem with the loan market, a deal this junky would not be getting done.
Another new worry of equity investors is that if the economy slows more, enough loans will be downgraded to triple-C that the caps that CLO’s have on triple-C debt will bust and be a negative for the whole lending and CLO market.
Widespread downgrades are always a problem for the credit market. However, we remind people that the ratings agencies are slower to recognize a crisis than even the Federal Reserve!
Thus, wholesale ratings downgrades tend to come a year or so after a crisis has begun, and only result in a secondary or tertiary decline in financial asset prices.
His conclusion: “Investors gobbled up $2.2 billion of new CLOs in the first three days of this week. That does not sound like a market with a problem to us.”
Perhaps not, but while this particularly optimistic take was the consensus as recently as a few weeks ago, it is quietly becoming the “variant perception” among fixed income commentators.
The first to highlight last week that “beneath the veneer of relative spread resilience and muted realized defaults, the weak links in the leveraged credit markets are coming under pressure” was Morgan Stanley, which highlighted two specific fault lines: the first was spread decompression, a dominant theme in both leveraged loans and HY, with the B-BB basis expanding by ~24bp in HY and ~56bp in loans from the January tights…
… while the second is that distressed tails in both asset classes are also back on the rise, and while energy remains the dominant contributor to the HY tail, Morgan Stanley finds more sector diversity in loans trading below 90 cash price.
The third, and most notable tell that something was wrong with credit, is that big price/spread moves are happening more frequently, “even outside the stressed buckets”. Worse, the big price moves exhibit a strong downside skew, particularly in the case of facilities that started the year at stressed levels.
One possible explanation for these sudden repricings: investors are anticipating declining fundamentals in the form of ratings downgrades. As MS notes, consistent with the price discontinuity patterns, net downgrades in leveraged loans have also accelerated in recent months – up 106% YoY and tracking the highest levels since the energy crisis.
And while Brian Reynolds may be right that “ratings agencies are slower to recognize a crisis than even the Federal Reserve”, the fact that we have witnessed the fastest uptick in bearish sentiment in terms of rolling 3-month net downgrades in recent months (as the LCD chart below shows), has not been lost on anyone. And if indeed one believes that rating agencies are merely there to be disparaged, then the spike in downgrades is even more ominous: after all if it is so obvious to the raters, what does that mean for everyone else who actually manages money for a living?
What it also means is that global banks are involuntarily stocking up on risky corporate loans as a result of investors beginning to cut risk in the credit markets, according as we reported last week. Underwriters that could once easily offload risk associated with corporate debt are finding that coming up with greater fools is becoming increasingly complicated, and a result, banks like Barclays and Deutsche have been stuck with over $2.5 billion in leveraged loans that they’ve been unable to sell in recent months.
While the amount of deals that have ended up in “clogged piping” is still small relative to the nearly $170 billion in leveraged loans issued this year in the U.S. and Europe, it’s notable due to the “broad strength” of the credit markets of late. It is also the case that when “clogging” begins, the amount of stuck deals is always small in the beginning, but certainly not the end.
And while the recent stalled deals don’t pose a major threat to the junk bond market (yet), an uptick could constrain underwriting and signal further risk aversion going forward.
Steven Abrahams, head of strategy at Amherst Pierpont Securities said: “The mix of loans coming to market right now is very difficult to absorb. It’s a very unusual story that leveraged loans and collateralized loan obligations are showing stress, even though the rest of the market is pretty benign, if not bullish.”
What is most ominous, however, is that the banks themselves are starting to cry uncle.
Speaking to Bloomberg TV on Friday, Barclays CEO Jes Staley, whose bank is sitting on hundreds of millions of dollars of risky corporate loans it’s been unable to sell, warned of the dangers of poorly structured deals.
Buyers of leveraged loans are shunning transactions that aren’t “structured properly,” Staley said in an interview with Bloomberg TV on Friday. Banks globally have been left holding parts of loans that funded at least seven private-equity deals, and Barclays was a lead underwriter on four of them.
For Staley, having experienced first hand how badly clogged the loan market can get, troubled loans are “eye-opening”:
“If you have a deal that’s not structured properly, that has some idiosyncratic weaknesses to it, the market can be pretty punishing at the bottom end,” said Staley, adding that “It’s a market that you have to have your eyes open to, you can still get the strong deals done.”
“We’re very comfortable with our portfolio, with our performance in the third quarter, but a couple of idiosyncratic deals have opened people’s eyes that it’s not a free ride right now” Staley said. The CEO (who was inexplicably close to Jeffrey Epstein) is right: it certainly isn’t a free ride, and after nearly 52 consecutive weeks of constant loan fund outflows…
… it will only get more complicated.
But not just yet, and as Bloomberg wrote last Friday, for now it’s time to party as the leveraged loan market’s annual shindig kicks off in New York next week… But not before even the central banks get in on the warnings.
Last Thursday, the Bank of Japan issued a report that warns of the potential for market-price risk in top-rated collateralized loan obligations – which as regular readers will recall are some of the most aggressive, “no questions asked” buyers of loan deals – if a material number of underlying loans rated single B are downgraded to CCC, something which as Morgan Stanley discussed last week, is virtually assured:
Net downgrades in leveraged loans have also accelerated in recent months – up 106% YoY and tracking the highest levels since the energy crisis. Meanwhile, 6% of loan facilities that were rated B or better at the beginning of the year have migrated into the B- bucket YTD, while the YTD downgrades from B- are 16%. These ratings transition trends increase the risk of a negative price feedback loop developing in B- and CCC credits, as they become a pinch point for CLO holdings.
Net downgrades are on the rise in HY bonds even after adjusting for energy. Stress is particularly concentrated in the single-B buckets, where MS counted ~160 downgrades in the HY index so far in 2019, roughly the same as the count for the whole of 2018 but the upgrade count is significantly lower (140 this year versus 235 in 2018). The next chart shows the net transitions across the different ratings categories and highlights that the deterioration in ratings profile is broad based. The inflection versus last year is particularly pronounced in the single-B buckets, tracking 12% for the B (flat)notch.
These accelerating net downgrades are also exacerbating the quality skew in CLO portfolios, ostensibly the biggest sources of demand for leveraged loans. As MS notes, the economics of CLO creation have prompted managers to run an overweight in the B ratings bucket versus the LSTA loan index for some time now. Higher downgrades and lower repayment rates in Bs have therefore further exacerbated the quality distribution within CLO portfolios. As shown below, 2.0 CLOs now own 62% of the outstanding B- market and 58% of all B rated facilities (by par). However, for the CCC and BB rated facilities, CLO ownership rates drop to 25% and 39%. This indicates that the shift in ratings mix has been mirrored in the larger loan index; indeed, we see that the share of B- loans in the index has increased by 2.3% since the end of April.
“This year’s conference will likely focus on CCC downgrades,” which is “more of a coming attraction,” said Asif Khan, a managing director and head of CLOs at MUFG Securities. “It will also focus on defaults, Libor discussions and the trajectory of the economy.”
And with some CLOs already exceeding their 7.5% CCC limits, it could potentially lead to payments being cut off to investors holding the equity, or first-loss piece. “Currently, aggregate CLO CCC-rated loan holdings are between 3.5% and 4.1% against a test level of 7.5% for most CLOs, which would suggest credit conditions must turn considerably before this is a concern for the loan market,” said Lee Shaiman, executive director of the LSTA, in an e-mailed statement.
Meanwhile, the BOJ focused on the CLO AAA tranches and found that while they are okay from credit fundamentals standpoint, a series of stress tests showed that AAA prices could fall about 10% due to an increase in spreads amid a severe downturn, and up to 30% if AAAs are cut to AA or single A.
The BOJ said prices could fall further due to an increase in durations, in an acute slump, as CLO managers may have trouble refinancing. An additional worry, CLOs may not be as diversified as the market thinks.
“While the analysis here only covers CLO investment, financial institutions should appropriately identify and manage the risk profiles of their overall overseas credit investment, such as in investment-grade corporate bonds, high-yield bonds, and investment funds, in preparing against a future global recession and adjustment in overseas credit markets.” the BOJ’s report warned.
In summary, the BOJ analysis shows that “the possibility that the diversification of risk in the CLO investment is not as high as it might appear, due to the overlap of underlying assets.”
Why is the BOJ paying particular attention on AAA CLO tranches? because recall that Japanese banks hold about 15% of global CLOs, and none bigger than Norinchukin Bank – better known as Nochu – a lender to Japan’s farmers and fisherman, which in mid-2019 restarted purchasing CLOs after dramatically cutting back earlier this year amid heightened market scrutiny.
How big is Nochu in the US CLO market? Let’s just say there is no single bigger player, and until very recently it was a massive presence in the $600 billion CLO market, buying as much as half of the highest-rated bonds in the fourth quarter in Europe and the U.S.
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Meanwhile, discussing the clogging in the loan market and the sharp declines in the price of some leveraged loans in recent weeks – both a clear early warning that something is very wrong with the loan market – Jerry Cudzil, head of U.S. credit trading at TCW Group said that “It is extreme bifurcation,” which has reduced investors’ risk tolerance. When stuck with unsold loans, banks often work with private equity sponsors to restructure the financing, typically with an injection of additional equity. If no solution is found, they’re ultimately on the hook to provide the funds at the original terms. And, as Bloomberg notes, to limit any member of the syndicate from offloading the debt at fire-sale prices, they often sign pacts that prevent one another from selling for a period of months below a certain threshold. In a best-case scenario, market sentiment or company fundamentals improve to an extent that the underwriters can attract buyers above the set level.
For some of the currently hung deals, that’s a tall order for now. “It is late cycle and there is growing risk of credit accidents,” Cudzil said. “We kill so many loans in the early stages that we are not even going to look at a cabinet maker right now.”