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Likely return and risk shift but remain attractive

admin | November 30, 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 leveraged loan market looks likely to come under some of the same pressure as other parts of the credit markets next year as rates edge up and concerns about US economic growth build. Performance relative to other major asset classes should weaken, but it would have to weaken dramatically to become a drag on portfolio performance. Rising rates could be a clear pressure point since the $1.1 trillion market largely floats off of 1- and 3-month LIBOR. And managers could see their limits on ‘CCC’ credits tested. Going higher in CLO capital structure, shorter in weighted average life and away from exposures to cyclical sectors should help.

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Shifting but continuing relative value

Even though leveraged loans may struggle next year to match their performance of the last few, they still should turn in some of the market’s better risk-adjusted returns—returns investors can either leverage or deleverage in CLOs. Average annual return on loans have run around 4.5% over the last decade with an annual standard deviation of 3.0%, one of the better combinations among major asset classes (Exhibit 1A). Those numbers mask significant year-to-year variation, of course, but even in the 5-year window bracketing the crisis years of 2008 and 2009, leveraged loans finished second only to agency MBS. Since 2013, performance has topped other major assets. Loans also have shown low correlation to other assets, adding to potential value as part of a portfolio (Exhibit 1B). Loans nevertheless look unlikely to match their recent strong performance over the next few years for a number of reasons: among others, exposure to rising rates and a potentially decelerating economy, an 80% share for covenant-lite loans in this year’s issuance and a 28% share for loans from M&A that rely on future projected revenue gains or cost savings. Both the return and volatility gaps between leveraged loans other assets look set to shrink in coming years. Leveraged loans still should play an important portfolio role, especially as a better source of corporate credit exposure than large parts of the investment grade market.

Probability that leveraged loan performance weakens against agency MBS or ABS: 60%. Probability that performance weakens against investment grade corporate debt: 20%.

The trade: Deleverage exposure to loan performance by going up in the CLO capital structure.

Exhibit 1: Leveraged loan performance should fall below historic levels next year but still remain attractive

Note: returns March 2007 to October 2018. Source: S&P/LSTA index for leveraged loans, Bloomberg/Barclays indices for other assets, APS calculations.

The risk of rising rates

Since almost all of the $1.1 trillion leveraged loan market floats off of 1- or 3-month LIBOR, this market more than any other in corporate credit could feel the pinch of higher interest rates. With 3-month LIBOR already up 100 bp this year, the process has already started. Gross cash flow for the average leveraged borrower stood at 4.3x the interest expense at the start of this year but only 3.2x recently (Exhibit 2). Another 50 bp rise in 3-month LIBOR without a lift in gross earnings could drive the ratio below 3.0x, a level historically associated with rising leveraged loan defaults within two years. Higher earnings could offset higher interest expense, of course, but that should depend on continued robust economic growth. The market could get caught between a Fed focused on raising rates to fight inflation on the one hand and decelerating economic growth on the other. Amid other pressures on CLO spreads—from wider investment grade and high yield spreads to slightly wider spreads in MBS—concern about leveraged loan credit could add to the mix.

Probability of a 50 bp or higher move in 3-month LIBOR: 25%. Probability of average EBITDA/cash interest falling below 3.0: 10%

The trade: move higher in the CLO capital structure, move to CLOs with shorter expected average lives, or do both to limit spread exposure. Move away from CLOs with heavy exposure to sectors sensitive to rising rates and slower growth such as energy, commodities and consumer discretionary.

Exhibit 2: Interest coverage has dropped this year as rates have moved up

Pressure on ‘CCC’ limits

The amount of ‘CCC’ CLO collateral has ranged from 3% to 4% over the last year, well under the typical 5.0% to 7.5% limit for ‘CCC’ exposure in most CLOs. And the number of CLOs failing this test also has drifted down. But the leveraged loan market in general could see a material pick up in ‘CCC’ loans if higher rates, a slowing economy or both put a squeeze on balance sheets. Around 9% of outstanding leveraged loans currently have a ‘B-‘ S&P rating and another nearly 28% have a ‘B’ rating (Exhibit 3). Modest pressure on these loans could quickly drive ‘CCC’ exposure in some CLOs above allowable levels, forcing the deal manager to haircut the loan to market value and putting pressure on par overcollateralization tests.

Probability of a rise in ‘CCC’ CLO exposure above deal limits: 10%

Exhibit 3: Pressure on ‘B-‘ loans could push CLOs toward limits on ‘CCC’ debt

Source: S&P Global Market Intelligence

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