Some leveraged credit investors like what they see

| November 15, 2019

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. This material does not constitute research.

Out along the West Coast this week among investors in leveraged credit, the outlook was as balanced as the weather. Some clouds, but more sun. Leveraged loans and the CLOs that buy them have traded poorly against almost all competing credit this year, especially since May. But consensus sees the weakness as unique to leveraged lending and not an early warning of broader problems. There’s some optimism and an early sense of opportunity.

The situation in leveraged lending

The leveraged lending market has traded in its own bubble this year. Spreads on the weakest leveraged loans have widened significantly against almost everything. The spread between ‘B’ and ‘BB’ loans, for instance, stood at 100 bp in June and more than 220 bp recently. Leveraged loans have widened to similarly rated high yield debt even though loans have recourse to corporate collateral and the debt often does not. The CLOs that buy leveraged loans have widened, too, against similarly rated investment grade and high yield corporate debt.

A few investors this week pointed out that wider spreads themselves raise the risk of downgrade on the weakest leveraged loans. These borrowers by definition have the least amount of room for balance sheet error. But wider spreads will likely put some borrowers in a tough spot if they have to issue or rollover debt at current levels. Rating agencies may tap these borrowers. And because ‘B’ loans have reached a record 65% of the $1.25 trillion syndicated loan market, the count of ‘B’ loans downgraded could set records even if the share of loans downgraded falls in line with past episodes of economic weakness.

The increasing important of CLOs in the leveraged loan market has magnified the market’s weakness. CLOs to date this year have bought nearly 72% of new loan issuance, a record, partly reflecting the steady withdrawal of retail loan funds. But CLOs are poorly equipped to keep buying ‘B’ credits. Those credits could easily slip to lower ratings and trigger CLO deal provisions that divert cash flow from equity and sometimes lower-rated debt to the most senior classes. CLO investors are also nervous about loan prices, penalizing managers that hold too many loans that drop significantly in price. With a lot of ‘B’ loans, a lot of price bombs have exploded this year, making CLO managers and investors jumpy.

Calm among the lenders

Investors watching leveraged lending ask the fair question of whether recent developments signal anything beyond natural repricing of the most vulnerable credits in an economy that has slowed from 3.5% real GDP in mid-2018 to less than 2% lately. At least a few 20-year vets of leveraged lending this week see it as a confluence of risk and slowing growth. Loans with the highest ratio of debt to earnings, the lowest ratio of earnings to interest expense and the most reliance on cost savings and synergy from corporate restructuring are the most vulnerable to slower growth. The biggest difference this time, they say, is that there are a lot more of these weak loans. Investors in leveraged loans take risk on the path of economic growth. The path since mid-2018 has run slightly against them.

The weakness of leveraged loans set against the strength in other credit markets has started conversations in San Francisco towers and along Southern California freeways about launching funds to buy leveraged loans made to good credits swept up in widening spreads. These investors want to step in where retail funds have fled the market. The weakness in CLO ‘BB’ debt, the part of the debt structure most sensitive to falling loan prices, has drawn interest from a growing list of buyers that see compelling value against high yield debt and have the patience to wait out another three to six months of volatility in ‘B’ loan prices.

There is also a sense that the economy in the fourth quarter of this year has found a bottom and that a few quarters of stable or even marginally better growth could revive loan and CLO performance. The Congressional Budget Office and many economists project flat growth from here. The Fed has taken out its mid-course insurance policy by cutting rates. Both the US-China trade war and Brexit have stepped back from the cliffs for now and, although still unpredictable, may be chastened by the reactions of markets and the voting public.

There is a possibility that even natural erosion of a large set of weaker credits could have impact beyond the borrowers themselves. The financial stability regulators, including the FDIC recently, have kept a close eye on the possible impact on banks. Direct bank exposure to leveraged loans and CLOs is well measured and monitored. Leveraged borrowers that lose access to capital markets could nevertheless have trouble repaying other bank loans, not to mention lost fees from arranging and syndicating leveraged loans. But regulators also note that low interest rates and generally good profits have helped corporations meet their debt service.

The leveraged lending crowd in California did not talk about recession, but instead about the possibility of steady, modest growth. For debt investors, that amounts to a good day, or many good days. Growth is not so strong that it drives up rates and corporate debt service or pulls risk capital into equity. Growth is not so weak that it raises the prospects of rising defaults. That would make for good days and nights for many debt investors in California and beyond.

* * *

The view in rates

The Fed looks very likely to stay on hold through next year. That should pin down rates in the front end of the curve. The market currently implies a 70% probability of another cut by the end of 2020, but that is likely predicated on continuing deceleration in the economy. Look for a plateau in growth instead. A plateau in economic growth should also relieve concerns about recession and allow yields in the long end of the curve to rise. The curve should steepen. Volatility should drop. The wildcards remain US-China trade and Brexit for now, but the pressure there has dialed back. A halt or rollback in tariffs or a reversal in Brexit would likely both push longer rates up quickly.

The view in spreads

Stable growth around 2% would be goldilocks for credit, and that is a likely outcome. Investment grade and high yield credit broadly should continue to tighten. The weakest part of the leveraged loan and CLO markets could widen, but that’s an idiosyncrasy of heavy issuance of weak loans into a market dominated by CLOs, which are ill-equipped to absorb the supply. There is fourth quarter liquidity risk as banks start to draw down balance sheets. Less liquid names in investment grade and high yield should widen to more liquid names, and more complex products should widen to simplier. MBS has lagged credit as heavy volumes of refinanced loans flowed through the market. But refinancing peaked in October and spreads should start tightening.

The view in credit

Even steady 2% growth will catch the most leveraged credits, and spreads in leverage loans reflect some of that concern. Leverage in investment grade corporate credit also has trended up this year, but an accommodative Fed has provided a buffer. As for the US consumer, low unemployment, high income and high aggregate household wealth leave consumer balance sheets in good shape. The readiness of the Fed, the ECB and other central banks to backstop growth makes broad recession unlikely. The weakest credits should feel a slowing economy, but without recession, the averages should remain good.

john.killian@santander.us 1 (646) 776-7714

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