Sounding the Alarm on Leveraged Loans?

Last week, Lisa Lee of Bloomberg reported, Leveraged Loan Investors Worry Good Times Will Soon Haunt Them:
One of the safest ways to invest in junk-rated companies is starting to look pretty risky.

Money managers have grown increasingly concerned about loans to high-yield corporations over the last month as early signs of slowing global growth have emerged. Investors are starting to realize that a key safeguard that protects them, namely the collateral they can seize if a company goes under, gives them less cover than they thought.

In December these worries helped push down prices in the $1.3 trillion leveraged loan market, hitting the debt that financed some of the biggest buyouts of 2018. In the go-go credit markets of the last two years, companies won unprecedented power to sell businesses, move operations to different units, and use other tactics to move assets out of the reach of lenders before defaulting.

“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.”

The loose contract provisions that money managers have agreed to over the last two years mean that when borrowers actually do start going under en masse, creditors are likely to end up with fewer assets to liquidate, and ultimately bigger losses. Private equity-backed firms have generally been the most aggressive borrowers when it comes to pushing for the right to move around collateral.

When Blackstone Group bought out a majority stake of Thomson Reuters Corp.’s financial terminal business last year, its $6.5 billion loan offered it wide latitude to sell assets and pull cash from the company. Soon after that Bloomberg reported that the business, dubbed Refinitiv, was looking at offloading its currency trading unit, among others. These concerns along with broader market volatility helped push the bid on these loans as low as 93.375 cents on the dollar in December, from their initial sale price of 99.75 cents.

Loans sold to help finance another leveraged buyout in September for Envision Healthcare have similarly fallen, to 93.75 cents from their original 99.5 cents. Investors have grown more worried that private equity owner KKR can easily sell off a more profitable portion of the company’s business and leave lenders with the less attractive part, according to people with knowledge of the matter.

Sometimes loan investors don’t realize the extent of the rights they’ve given to a corporation and its private equity owners until assets are taken away. The contractual provisions that allow greater flexibility, known as covenants, may be spread through a lengthy lending agreement. Only careful consideration of how different lending terms interact with each other reveals what a company can do.

“There are covenants that put together can make a loan like an equity,” said Jerry Cudzil, head of credit trading at money manager TCW Group Inc., which oversaw $198 billion of assets as of Sept. 30. Equity usually has the last claim on assets when a company is liquidated, making it the riskiest kind of investment in a company.

More Risk

Weaker collateral protection is just one factor that makes loans to junk-rated companies much riskier in this cycle than they’ve been in previous downturns, and one factor spurring investors to pull money from leveraged loan funds. Companies have more debt relative to their assets than they had in the past, which means that if a failed corporation liquidates, the proceeds have to cover more liabilities.

On top of that, a higher percentage of loan collateral is intangible assets -- about two thirds, up from about 60 percent in 2009, according to UBS Group AG. Those kinds of assets, like brand names, are harder to value and liquidate than tangible assets. And more borrowers have just loans and no other form of debt this time around, meaning if the company fails, there are fewer other creditors to absorb losses.

A key to loosening investors’ hold over collateral has been tweaking the tests that determine if a company is earning enough relative to its debt obligations, known as leverage. As long as corporations are generating enough income, managers often have the freedom to move assets around and pull money from the company, among other things. Companies have been easing the requirements for these tests, making it easier for them to clear the hurdles and keep their flexibility.

“These leverage tests are like a master key that unlocks all these flexibilities,” said Derek Gluckman, analyst at Moody’s, “and the master key is working better and easier.”

J. Crew

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. But the company has showed signs of recovering, and its term loan now trades at 92 cents on the dollar, up from around 55 cents in November 2017.

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.

“If new terms get through, all the private equity firms and their counsels start to claim that the new term is becoming standard in the market and they point to the precedent,” said Justin Smith, an analyst who looks at high-yield lending agreements at Xtract Research. “There are too many lenders who don’t care enough about covenant packages or don’t pay attention.”
Since diving in December when the leverage loan market basically froze, things have stabilized and improved.

Still, as Adam Tempkin of Bloomberg reports, Leveraged Loan Rally May Be Double-Edged Sword for CLOs:
The rally in leveraged loans may produce mixed results for collateralized loan obligations, which could stand to benefit from improved sentiment overall but lose some of the all-important arbitrage that helps the deals work.

The January rebound was seen across the board in risk assets, which should also boost CLOs by tightening spreads after they reached year-long wides in December amid falling leveraged loan prices. But rising loan prices typically crimp returns for CLO equity investors, a critical buyer base.

CLOs buy leveraged loans and repackage them into bonds for sale to Wall Street. They work by arbitraging the gap between the money brought in from the loans and the cost of borrowing for a CLO manager. Equity investors receive any excess cash flows between the two after the debt investors are paid in full.

"The arbitrage is improved with recent loan price volatility but it is still difficult to get a firm sense without knowing yet where primary AAA bonds will price," said Daniel Wohlberg, vice president at Eagle Point Credit Management. "In the new year, there hasn’t been a lot of certainty of what the AAA spread level is yet."

At this point it’s hard to determine the loan rally’s effect since no CLOs have come to market in 2019. “There is little visibility now,” said Maggie Wang, head of U.S. CLO research at Citigroup Inc.

As bad as the CLO spread widening has been, it lagged that of underlying loans in December, so the arbitrage may still improve, experts say.

“There is some relief to the arbitrage,” JPMorgan Chase & Co. analysts led by Rishad Ahluwalia wrote in a recent research note late last year. “So it’s possible open CLO warehouses may be motivated to price (if taking mark-to-market losses in the loan selloff), and momentum picks up. Also, over the last 19 years and three cycles, CLOs tend to tighten in January.”

While the arbitrage may be recovering, it is still relatively weak, especially considering that average AAA spreads have widened to 126 basis points over Libor in December from a tight of 97 basis points in March, the narrowest of the year. There are also fewer leveraged loans available to ramp up deals.

The CLO market is coming off its strongest post-crisis year, with more than $130 billion sold and outperforming other segments of fixed income in returns for most of 2018.

Several banks, including Wells Fargo & Co. and Deutsche Bank AG, predict slightly weaker gross supply this year at $110 billion. Morgan Stanley estimates supply as low as $90 billion, as CLO equity may not look favorable against the late-cycle backdrop, while at the other extreme JPMorgan expects a new annual record of $135 billion.

“New-issue CLO issuance is contingent on current AAA levels but so far this year there has been a technical quiet due to recent market uncertainties but we expect issuance to pick up in the near term,” Eagle Point’s Wohlberg said.
There remains a lot of concern on leveraged loans and CLOs. In December, the ratings agencies sounded the alarm, not only about the continued rise in leveraged lending and issuance of Collateralized Loan Obligations (CLOs), but also about the deteriorating credit quality of both:
[...] Moody’s released ‘From covenants to cushions: Top 10 credit challenges CLOs face today’ a report with stark warnings about expanding risks, especially arising “from growing weaknesses in the leveraged loan market, the loosening of transaction constraints and the changing regulatory and macroeconomic environments.” Moody’s warnings are important, because CLO issuance in the U.S. has risen over 60% just since 2016. Significant issuance is not necessarily the problem when an economy is in growth mode as it has been in the last couple of years. Yet, market signals and macroeconomic data are pointing to a a slowdown as early as next year (2019).

The worrisome issue here is that almost 85% of leveraged loans outstanding are covenant-lite. In an economic or market downturn, investors who end up holding these loans directly or through CLOs, will have little to protect them from significant losses.

And that's where the trouble might happen for pensions investing in private equity funds that are active in this space or that engage in leveraged loans directly through their internal private debt operations.

Interestingly, KKR's Henry H. McVey put out his outlook today, Outlook for 2019: The Game Has Changed, where he admitted the private equity giant is cutting its allocation to leveraged loans:
After over two years of leaning-in to Leveraged Loans as a pure play idea, we are reducing this overweight to zero from three percent and a benchmark weighting of zero.

Leveraged Loans have had a great run in recent years, as their floating rate feature and strong technical flows have served this asset class well, particularly relative to High Yield.

Where to go in corporate credit? We now hold a seven percent position in Actively Managed Opportunistic Credit, which provides us with greater ability to toggle between High Yield, Structured Credit, and Loans. Said differently, given the dislocation of late, we want a little more flexibility to arbitrage capital structures and asset classes than in the past. We also like this vehicle because it is a direct play on our Buy Capital Structure Complexity thesis.
Importantly, he added: "Liquid Credit has priced in the growth slowdown we are forecasting in 2019 much more appropriately than many parts of Private Credit have, and as such, we skew the portfolio heavily in this direction."

Zero Hedge picked up on this and published a comment, KKR Sounds Alarm On Leveraged Loans: Cuts Allocation To Zero where it showed the fund's trimming in Leveraged Loan exposure (alongside the fund's 0 allocation to junk, high grade and EM debt; click on image):

Now, Zero Hedge being Zero Hedge, it likes to sound the alarm on everything that looks remotely bearish on markets, but it's definitely worth paying attention to trends in the leveraged loan markets and CLO issuance in general. There's been a boon in private debt and things gotten a little out of whack with all these covenant-lite loans which is why KKR wisely decided to cut its allocation.

A friend of mine put it this way: "Because of historical low rates, everyone is chasing yield everywhere. Spreads have come in so much on corporate bonds that private equity funds decided to loan money to businesses that would otherwise not have gotten credit through public markets and collected yield on those loans. But even there, when everyone started doing it and going covenant-lite, it became riskier and riskier to collect that extra yield."

All this to say if I was sitting on the board of major pension funds, I'd definitely like to know the exposure to leveraged loans through private equity sponsored CLOs or through direct internal operations.

But it's also important to remember pensions that deal directly in leveraged loans have a much longer time frame than private equity funds and that allows them to ride out rough patches.

Still, given the explosive growth of this market, it's important that risk teams understand the macro and micro risks very well and their exposure to these markets and contagion risks across all asset classes.

As I discussed in my Outlook 2019, (liquid) credit markets (HYG) have bounced back nicely recently, as have emerging market stocks (EEM) and bonds (EMB). Even a popular leveraged loan ETF, the Invesco Senior Loan ETF (BKLN), has bounced back very nicely back above its 50-week moving average (click on image):

Whether this is a brief relief rally before the next downleg remains to be seen but so far, things don't look anywhere near as scary as in late December when the market froze up.

Below, AllianceBernstein’s Distenfeld, Aberdeen’s Hickmore, and Eaton Vance’s Gaffney, discuss why the leveraged loan market looked very scary in mid December, explaining why outflows from liquid ETFs or mutual funds that track leveraged loans creates liquidity crunches in these ETFs and can freeze the leveraged loan market (basically, there's a liquidity mismatch between ETFs that settle daily and loans that settle in weeks).

CNBC's Leslie Picker also discussed new worries for Wall Street in the leveraged loans market back in December, and it's worth listening to her comments too.