Checking expectations on leveraged loans
admin | October 19, 2018
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The performance of leveraged loans as an asset class has been a bright spot in fixed income, but the market continues to give investors good reason to check expectations. Leverage by a number of measures continues to rise, and spreads seem to only reluctantly reflect it. The asset still deserves an important role in a well-diversified portfolio, but the size of that role could come under pressure.
The past performance of leveraged loans may arguably be their strongest credential. Both through the 2008 financial crisis and afterwards, leveraged loans turned in a strong combination of risk and return (Exhibit 1). From March 2007 through January 2013, leveraged loans turned in a 5.0% annual rate of return with a 4.1% annual standard deviation. Of major asset classes reviewed here, only agency MBS and investment grade emerging market debt topped that combination. From January 2013 to the present, performance only improved. Leveraged loans turned in a 4.1% annual return with only a 0.95% standard deviation. No other asset class came close.
Exhibit 1: Leveraged loans have turned in a good mix of risk and return
Leveraged loans also have shown clear ability to diversify a broad fixed income portfolio. The correlation of their returns with other major assets’ as been relatively low (Exhibit 2). When it comes to Treasury returns, the correlation has been persistently negative for good reason: in strong economies with improving fundamentals for leveraged borrowers and tightening loan spreads, Treasury yields tend to rise, and in weakening economies the reverse tends to play out. Assets with good base return potential and negative correlation with core interest rate risk are hard to find, and valuable.
Exhibit 2: Returns on leveraged loans have shown low correlation to other fixed income sectors
But asset allocation is always about updating expectations for risk and return, and risk in some loans may be rising faster than potential return. Nearly 34% of all new leveraged loans issued this year have come from mergers or acquisitions (Exhibit 3), and in many of these loans leverage rises materially if the deal fails to realize anticipated cost savings, revenue growth and other synergies. A recent S&P/LCD study found the average debt/EBITDA ratio of 2018 M&A deals rose to 5.8x without synergies – roughly a third of a turn higher than the 5.5x with synergies. And exposure to higher potential leverage is increasing. The average amount of debt used to fund buyouts and M&A has jumped this year from $890 million in the preceding three years to an 11-year high of $950 million. This issue adds to others on investors’ list such as the sharp rise in new issuers and the persistent rise of covenant-lite loans.
Exhibit 3: M&A is driving a sizable share of leveraged loan issuance
Using history as a guide, investors probably should revise return expectations down and risk up to somewhere between the mix realized from 2007 to 2013, and the one from 2013 to the present. Even if leveraged loans fall short of the performance of the last five years, the risk-return and diversification are still likely to compare well to most other major asset classes.
The view in rates
The sharp move in 10-year Treasury rates from below 3.10% to near 3.25% is steadily fading into the rearview mirror. The latest FOMC minutes and occasional remarks from various governors continue to make clear the Fed’s intent to hike through most of 2019. That’s not good news for the front end of the yield curve. The back end of the yield curve continues to price in real rates of 1.08% and inflation expectations of 2.11% that continue to slip by the day. Barring another repricing of growth higher, it’s hard to see 10-year rates sustained above 3.20%. Look for those rates to drift a little lower and for the yield curve to resume its flattening.
The view in spreads
The corporate market has become the primary driver of spreads, and the trend looks wider. Continued addition of leverage makes investment grade corporate debt riskier, and potential softening in GDP growth in the second half of this year only raises concerns. A drift wider in corporate spreads would likely pull agency MBS and other products along with it, although agency MBS would still likely benefit from investor interest in liquidity.
The view in credit
While the fundamentals of corporate balance sheets have some weak spots, they are harder to find on consumer balance sheets. Median household income is at a record along with household net worth, and household debt costs as a percent of disposable income are near a record low. If there is weakness, it’s in households with sizable student debt, and rising delinquencies in that asset signal that the debt is weighing heavily.